In two recent cases, the Delaware courts addressed the question of when a minority stockholder has sufficient influence over a corporation to be deemed a controlling stockholder. The issue typically arises in the context of a transaction between the minority stockholder and the corporation, such as an attempt to acquire the corporation’s publicly held shares. In such cases, the stakes for the minority stockholder can be quite high as transactions between a corporation and a controlling stockholder may be subject to the exacting “entire fairness” standard.
In October 2015, in Corwin v. KKR Financial Holdings LLC,[1] the Delaware Supreme Court focused the control inquiry squarely on the minority stockholder’s ability to influence the decision-making process of the board of directors. There, KKR & Co. (“KKR”), owner of 1% of the interests in KKR Financial Holdings (“Financial Holdings”), was seeking to acquire the 99% of the interests in Financial Holdings held by the public. Plaintiffs argued that, despite KKR’s minimal equity stake, the entire fairness standard should be applied to the transaction. They maintained that KKR had de facto control because Financial Holdings’ primary business was financing KKR-sponsored transactions and an affiliate of KKR managed the day-to-day operations of Financial Holdings under a management agreement that would be impractical to terminate.
The court conceded that Financial Holdings was “‘unattractive as an acquisition target to anyone other than KKR because of [Financial Holding]’s operational dependence on KKR’” and such dependence severely “‘limited [Financial Holdings’] value-maximizing options.’”[2] The court nevertheless rejected the control argument noting that KKR had only a minimal equity interest, no right to appoint directors, and no contractual veto rights over company actions. The court’s reasoning rested on the board’s ability to make an independent decision with respect to the proposed transaction:
“At 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 [the court] decline[s] to create such a rule . . . [T]here are no well-pled facts from which it is reasonable to infer that KKR could prevent the [Financial Holdings] 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 [Financial Holdings] directors from their offices if they did not bend to KKR’s will in their consideration of the proposed merger.”[3]
In February of this year, in Calesa Associates, L.P. v. American Capital, Ltd.,[4] Vice Chancellor Glasscock took up the control issue and provided some guidance as to the factors to be considered in examining a minority stockholder’s influence over the board decision-making process.
In Calesa, private equity firm American Capital owned a 26% stake in Halt Medical, Inc., held a $50 million Halt note, and had the right to designate two of the seven members of the Halt board. When Halt fell on hard times, the company and American Capital agreed to a transaction pursuant to which American Capital would loan Halt $73 million and American Capital’s equity stake in the company would be increased to almost 66%. In addition to alleging that the terms of the transaction were unfair, plaintiffs challenged the fairness of the process, alleging that the board did not have sufficient time to consider the transaction, did not review complete copies of the transaction documents, never held a meeting to vote on the transaction, did not consult a financial advisor, and was not permitted to explore alternatives.
In denying defendants’ motion to dismiss the complaint, Vice Chancellor Glasscock noted that he was required to “‘accept as true all well-pled allegations of fact and draw reasonable inferences in the plaintiff’s favor.’”[5] Applying that standard, he found that, although American Capital owned only 26% of the Halt Medical equity at the time of the transaction, plaintiffs “pled sufficient facts to support a reasonable inference that a majority of the Board was not disinterested or lacked independence from [American Capital], such that [American Capital] was a controlling stockholder at the time of the Transaction.”[6] Thus, the court concluded, for purposes of considering the motion to dismiss, “entire fairness review is triggered.” [7]
In his analysis, the Vice Chancellor focused closely on the relationships of four of the seven Halt directors with American Capital. Two of the directors were quite clearly conflicted — one was an executive of American Capital who negotiated the challenged transaction on behalf of American Capital, and one was a director of American Capital. A third director was the CEO of an American Capital portfolio company. The court explained that, while that fact alone may not be enough to establish a conflict, the Information Statement for the transaction conceded that the director had “interests that are in addition to or different than the interests of Halt’s Stockholders generally.” [8] Under the lenient standard applicable to a motion to dismiss, such disclosure, in the court’s view, supported a reasonable inference that there was a conflict of interest. Finally, the court found that the complaint included sufficient allegations that Halt’s CEO was under the control of American Capital. In particular, the court pointed out that, as a result of the transaction, the CEO became eligible to participate in a management incentive plan that would give him 6% of the equity in Halt, and in any event, his job essentially depended on American Capital’s support.
While Corwin helpfully establishes that a significant business relationship alone will not cause a minority stockholder to be deemed to have control over a corporation, Calesa provides a note of caution with respect to board decision-making. If a transaction between the company and the minority stockholder is under consideration, the minority stockholder and the company should carefully review the relationships between the directors and the stockholder, the stockholder’s veto rights, and whether it is likely that a company officer who sits on the board would be considered independent of the stockholder. In addition, in the course of a transaction, the implications of disclosure concerning the interests of directors should be carefully considered. Calesa also reminds us that, as always, process is crucial. In refusing to dismiss the complaint, the court certainly took note of American Capital’s alleged hard-bargaining, the speed of the transaction and the board’s alleged lack of care in making its decision.
[1] 125 A.3d 304 (Del. 2015).
[2] Id. at 307 (quoting In re KKR Fin. Holdings LLC S’holder Litig., 101 A.3d 980, 994 (Del. Ch. 2014)).
[3] Id. at 307-308 (quoting In re KKR Fin. Holdings LLC S’holder Litig., 101 A.3d at 994-95).
[4] C.A. No. 10557-VCG (Del. Ch., February 29, 2016).
[5] Id. at 19 (quoting Caspian Alpha Long Credit Fund, L.P. v. GS Mezzanine Partners 2006, L.P., 93 A.3d 1203, 1205 (Del. 2014)).
[6] Id. at 30.
[7] Id. at 23.
[8] Id. at 28.