Delaware Supreme Court Says that Minority Stockholder Which Manages Company’s Day-to-Day Affairs is not a “Controlling Stockholder” and Confirms that Mandatory Stockholder Approval of Merger Transaction Compels Application of Business Judgment Rule

The Delaware Supreme Court’s recent decision in Corwin v. KKR Financial Holdings LLC makes two important points about corporate governance litigation. First, the court rejected the novel argument that an owner of less than 1% of a company’s stock could be considered a “controlling stockholder” because it managed the company’s day-to-day affairs under a management agreement. Second, the court confirmed that when a transaction has been approved by a majority of the company’s disinterested stockholders, the highly deferential business judgment rule should govern any challenges to the transaction, even if the stockholder vote was statutorily required and not voluntary.

KKR Financial Holdings LLC was a Delaware limited liability company. It delegated its day-to-day operations of investing in corporate securities to a management company, pursuant to a management agreement. KKR Financial had no employees of its own and was completely reliant on the management company for its operations. The equity interests of KKR Financial were widely held, and the corporate parent of the management company owned less than 1% of the company.

The management company’s parent sought to acquire KKR Financial through a merger. After negotiations and some due diligence, KKR Financial’s board approved an agreement to merge the company with the management company’s parent. KKR Financial’s board then sought and obtained the merger’s approval by a majority of the equity holders in KKR Financial, excluding any equity interests held by the management company’s parent or any affiliates, and the merger was later consummated.

Some shareholders of KKR Financial thereafter sued KKR Financial’s board of directors for breaching their fiduciary duties in connection with the merger, and they also sued the management company’s parent as a “controlling stockholder.” The Court of Chancery dismissed the Complaint, holding, among other things, that the management company’s parent did not constitute a “controlling shareholder” and, also, that the business judgment rule provided the appropriate standard of review because a majority of disinterested shareholders had approved the transaction.

The Delaware Supreme Court affirmed the Court of Chancery on both grounds, in an opinion penned by Chief Justice Strine. A minority stockholder can be a “controlling stockholder,” the court reasoned, only if there is “a combination of potent voting power and management control such that the stockholder could be deemed to have effective control of the board.” Because the management agreement did not give the management company such extensive control over the affairs of the company that it could prevent KKR Financial’s directors from exercising their independent judgment, it was not a “controlling stockholder.”

Chief Justice Strine also confirmed that when an informed and uncoerced majority of a company’s disinterested shareholders approve a transaction – whether obtained voluntarily or as required by statute or corporate charter – the business judgment rule supplies the appropriate standard of review. While there is ample support going back decades for this proposition, it was called into some doubt by the Delaware Supreme Court’s 2009 decision in Gantler v. Stephens, where the court held that “the shareholders’ fully informed vote ratifying [the board’s decision]” did not require application of the business judgment rule because “the ratification doctrine does not apply to transactions where shareholder approval is statutorily required.” Chief Justice Strine confined Gantler to the “ratification” doctrine and held that that decision was not intended to upend decades of prior case law concerning transaction approvals. The KKR Financial decision therefore represents a reaffirmation that approval of a transaction by an informed and uncoerced majority of the board’s disinterested shareholders will be judged by the business judgment rule.

Christopher Walsh is a Director in the Gibbons Business & Commercial Litigation Department.
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