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In re KKR Financial Holdings LLC S'holder Litig., Consol. C.A. No. 9210-CB (Del. Ch. Oct. 14, 2014) (Bouchard, C.)

October 14, 2014

In this opinion, the Court of Chancery dismissed a purported class action by stockholders of KKR Financial Holdings LLC (“KFN”) challenging its acquisition by KKR & Co. L.P. (“KKR”) in a stock-for-stock merger, rejecting plaintiffs’ novel claim that KKR, which held less than one percent of the shares of KFN stock, was a controlling stockholder of KFN because an affiliate of KKR managed the day-to-day business operations of KFN pursuant to a management agreement.  The Court found that plaintiffs’ allegations did not support a reasonable inference that KKR controlled KFN’s twelve-member board of directors such that those directors could not freely exercise their judgment in determining whether to approve and recommend to the stockholders a merger with KKR. 

KFN, a Delaware limited liability company, was a publicly traded, specialty finance company whose business was generating income and capital appreciation, primarily through investing in sub-investment grade corporate debt securities.  KFN’s primary asset was a portfolio of subordinated notes in collateralized loan transactions that financed the leveraged buyout activities of KKR.

By way of background, in 2004, KKR formed KKR Financial Corp., a Maryland real estate investment trust (“KKR Financial”).  In June 2005, KKR Financial engaged in an initial public offering, the prospectus for which disclosed that KKR Financial would be “externally managed and advised by KKR Financial Advisors LLC, an affiliate of KKR, pursuant to a management agreement.”  The prospectus described the management agreement in detail.  In April 2007, KKR Financial announced a proposed restructuring pursuant to which it would be reincorporated as a subsidiary of KFN, a newly created Delaware limited liability company.  The transaction was subject to the approval of the stockholders of KKR Financial.  The prospectus for the transaction disclosed, among other things, that KFN would “assume all obligations of KKR Financial Corp. under the management agreement[.]”  The restructuring was approved by KKR Financial’s stockholders.

Under the terms of the management agreement, KFN delegated responsibility for its day-to-day operations to KKR Financial Advisors LLC (“KFA”).  According to plaintiffs, the management agreement made KFA responsible for, among other things, (1) selecting, purchasing, and selling KFN’s investments, (2) KFN’s financing and risk management, and (3) providing investment advisory services to KFN.  Plaintiffs also alleged that KFN was reliant on KKR to value its assets.  In exchange for the services they provided, KKR and its affiliates were entitled to a management fee.  The management agreement renewed automatically each year by its own terms.  According to plaintiffs, KFN and its stockholders could terminate the agreement under certain conditions, generally with nearly six months’ advance notice and with a termination fee of four times the average management fee for the preceding two years. 

Notwithstanding KFN’s reliance on KFA to manage its day-to-day operations, the management agreement explicitly provided that KFA would be subject to the supervision of KFN’s board of directors, and KFN’s operating agreement empowered its board using language similar to Section 141(a) of the Delaware General Corporation Law, stating that, except as otherwise provided therein, “the business and affairs of [KFN] shall be managed by or under the direction of its [b]oard of [d]irectors.” 

In October 2013, KKR expressed an interest in acquiring KFN to Paul Hazen, one of KFN’s directors.  On October 22, 2013, Hazen raised KKR’s interest in acquiring KFN at a KFN board meeting, during which the board granted KKR permission to use confidential information about KFN it had obtained through KFA’s service as manager in order to make an acquisition proposal.  After the board meeting, Hazen asked Craig Farr, a senior executive of KKR who was serving as President, CEO, and a director of KFN, whether KKR would consider modifying or eliminating the termination fee in the management agreement.  Farr contacted KKR and was informed that KKR was unwilling to do so.

On October 31, 2013, KFN formed a transaction committee to consider a potential transaction.  The committee was comprised of six of the twelve directors on the KFN board:  Tracy Collins; Robert Edwards; Vincent Finigan; Ross Kari; Deborah McAney; and Scott Ryles.  Edwards was named chair of the committee.  The committee retained Sandler O’Neill + Partners L.P. as its financial advisor and Wachtell, Lipton, Rosen & Katz as its legal advisor.

KKR initially made an all-stock proposal at an exchange ratio of 0.46 KKR units per KFN share.  The transaction committee recognized that an all-stock deal could be disadvantageous to KFN because its shares were trading near their one-year low while KKR’s units were trading near their one-year high.  The committee proposed a cash deal to KKR, but KKR rejected it.  The committee negotiated for improvements to KKR’s all-stock proposal, increasing the exchange ratio from KKR’s initial offer of 0.46 KKR units per KFN share to its “best and final offer” of 0.51.  KKR rejected the committee’s request for consideration of 0.52 KKR units per KFN share.

On December 13, 2013, the KFN board, excluding Farr and Scott Nuttall, met to discuss the proposed transaction.  The transaction committee then met and voted to recommend the proposed transaction to the KFN board.  The full KFN board, again excluding Farr and Nuttall, reconvened and approved the transaction.  Sandler O’Neill delivered a fairness opinion to the transaction committee concluding that the exchange ratio of 0.51 KKR units per KFN share (a 35% premium to KFN’s stock price) was fair from a financial point of view to KFN’s stockholders.  The merger agreement was executed on December 16, 2013.  The merger agreement required majority approval of shares held by persons other than KKR and its affiliates.  On April 30, 2014, KFN stockholders voted in favor of the merger, including a majority of the shares not held by KKR or its affiliates.

On December 27, 2013, the first of nine actions was filed in the Court of Chancery challenging the merger.  These actions were consolidated on January 31, 2014.  A consolidated amended complaint was filed on February 21, 2014, asserting three claims for relief.  Count I asserted that the members of the KFN board breached their fiduciary duties of care and loyalty by agreeing to the merger.  Count II asserted that KKR breached its fiduciary duty of loyalty in its capacity as a controlling stockholder by causing KFN to enter into the merger at an unfair price and following an unfair process.  Count III asserted that KKR and two KKR affiliates that were parties to the merger agreement aided and abetted the KFN board’s breach of fiduciary duty. 

On March 7, 2014, defendants moved to dismiss the complaint in its entirety under Rule 12(b)(6) for failure to state a claim upon which relief can be granted. 

The Court dismissed all three of plaintiffs’ claims pursuant to Rule 12(b)(6), concluding that “it [was] not reasonably inferable from the complaint that KKR was a controlling stockholder of KFN or that a majority of the KFN board was not disinterested or independent[,]” and that, “even if the majority of the KFN board was not disinterested or independent, business judgment review still applies because the merger was approved by a majority of disinterested KFN stockholders in a fully informed vote.” 

The Court first rejected plaintiffs’ argument that KKR was a controlling stockholder of KFN, reasoning that plaintiffs’ allegations indicated only that KKR, through KFA, managed the day-to-day operations of KFN, and “d[id] not support a reasonable inference that KKR controlled the KFN board—which is the operative question under Delaware law—such that the directors of KFN could not freely exercise their judgment in determining whether or not to approve and recommend to the stockholders a merger with KKR.”  The Court explained that, “[a]t bottom, plaintiffs ask the Court to impose fiduciary obligations on a relatively nominal stockholder, not because of any coercive power that stockholder could wield over the board’s ability to independently decide whether or not to approve the merger, but because of pre-existing contractual obligations with that stockholder that constrain the business or strategic options available to the corporation.  Plaintiffs have cited no legal authority for that novel proposition, and I decline to create such a rule.”  Accordingly, the Court dismissed Count II.

The Court next rejected plaintiffs’ contention that entire fairness review should apply to the merger because a majority of the KFN board of directors was not independent.  Two members of the twelve-member board, Farr and Nuttall, were high-level KKR employees at the time of the merger who did not vote on the transaction; the defendants did not contend that they were independent.  Conversely, plaintiffs did not contest the independence of four other KFN board members.

The Court found that it was reasonably conceivable that two other directors, Hazen and Glenn Hubbard, would not be found independent of KKR because, according to the complaint, Hazen had longstanding ties to KKR and served as a senior advisor to KKR and as chairman of a KKR affiliate, and Hubbard was Dean of Columbia Business School, which recently received a $100 million donation from KKR co-founder Henry Kravis.

The Court rejected plaintiffs’ challenges to the independence of the other four board members.  The Court found that the allegation that McAney was appointed to the board by KKR was insufficient to call into question her independence because “[i]t is well-settled Delaware law that a director’s independence is not compromised simply by virtue of being nominated to a board by an interested stockholder.”  The Court similarly found lacking plaintiffs’ allegation that Edwards was “beholden” to KKR because he “owes his position as CEO of Safeway to KKR-affiliated directors on the Safeway board,” finding the allegation conclusory in that the complaint did not allege “that those KKR-affiliated directors ever constituted a majority of the Safeway board or that they had the power to hire or promote Edwards.”  The Court likewise rejected plaintiffs’ challenges to the independence of Kari and Ely Licht, finding plaintiffs’ allegations of previous business relationships to be insufficient to support a reasonable inference that either was beholden to Hazen or to KKR.

The Court next held 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 of review still would 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.”  In so holding, the Court rejected plaintiffs’ argument that the stockholder vote was not fully informed because the proxy statement omitted material facts with respect to the independence of the transaction committee, the roles of Hazen and Farr in the merger negotiations, and the financial analysis of Sandler O’Neill.  The Court explained that the purported omissions were not material because directors need not “engage in self-flagellation and draw legal conclusions” nor provide explanations for “why” they took or did not take certain actions.  Because the business judgment standard of review applied to the merger, and because plaintiffs did not allege a claim for waste or gift, the Court dismissed Count I. 

Lastly, the Court dismissed Count III of the complaint because an aiding and abetting claim “may be summarily dismissed based upon the failure of the [underlying] breach of fiduciary duty claims against the director defendants.”

The full opinion is available here