United States: Getting A Deal Done In Delaware Without Revlon

In its recent decision of Corwin v. KKR Financial Holdings LLC, the Delaware Supreme Court did two things. It affirmed that a court will not apply an entire fairness review to a merger transaction so long as the board is disinterested and the acquirer does not have "effective control," no matter how closely tied the acquirer is to the operations of the target company. Second, it championed the informed and uncoerced vote of a disinterested majority of shareholders as a cure for many sins of the M&A process, including the failure to follow Revlon.

In 2004, KKR & Co. LP, the well-known publicly traded investment company ("KKR"), formed KKR Financial Corp., a Maryland real estate investment trust ("KKR Financial"), which in 2005 engaged in a public offering. Then, in 2007, KKR Financial restructured so that it became a subsidiary of KKR Financial Holdings LLC, a publicly traded Delaware limited partnership ("KFN"). The subsequent going-private transaction in 2013-2014, in which KFN was acquired by KKR, is the subject of the case.

Everything about KFN, except its ownership and the majority of its board, was tied to KKR. KFN's primary asset was a portfolio of subordinated notes in collateralized loan transactions that financed KKR's leveraged buyout activities. KFN delegated management responsibility for its operations to KKR Financial Advisors LLC ("KFA"). By its own statement, KFN was wholly dependent on KFA. Thus, KFN had no facilities or employees, and KFA was responsible for KFN's investments, financing, risk management and valuation of its assets. KFN's management agreement with KFA could be terminated only under certain circumstances and the payment of a substantial termination fee. As alleged by plaintiffs, the amount of the termination fee as of the end of 2012 exceeded the amount of cash and cash equivalents on the balance sheet of KFN at the time. On the other hand, KKR owned only a de minimis amount of the equity of KFN, and only two of the 12 directors on the board of KFN were clearly affiliated with KKR.

In late 2013, KKR expressed interest in acquiring KFN in a stock-for-stock merger. In the negotiations that ensued, the KFN transactions committee of independent directors succeeded only in extracting a minimal improvement in KKR's offer, from 0.50 to 0.51 KKR shares per KFN share. The exchange ratio reflected a 35% premium over the trading value of KFN shares on the date the merger agreement was executed in December 2013. Plaintiffs observed, however, that at the time the KFN shares were trading near their one-year low, while KKR shares were trading near their one-year high. The merger was approved by a vote of the KFN shareholders, and the merger was consummated in April 2014.

Plaintiffs claimed that the merger transaction should have been reviewed by the court under the standard of entire fairness rather than the far more lenient standard of the business judgment rule. The entire fairness standard is reserved for transactions with controlling shareholders, essentially because the controlling shareholder is positioned on both sides of the transaction. With KKR's tentacles wrapped around KFN in numerous directions, plaintiffs urged that KKR was indeed a controller of KFN. The Delaware Supreme Court, agreeing with the court below, gave this argument short shrift. While KKR controlled the operations of KFN, it owned virtually no stock, and the board was largely independent of KKR. KFN's almost total operational dependency on KKR was of no consequence. KKR did not have what was termed "effective control" over KFN, that is, "a combination of potent voting power and management control." The court's decision is consistent with its holding in Kahn v. M&F Worldwide Corp. The court held in that case that given an independent committee of directors and a majority vote of disinterested shareholders, the business judgment rule will apply even in transactions with an undeniable controlling shareholder.

Plaintiffs next argued for relief on the basis that the KFN board failed to conduct a sale process that complied with its duties under the famed case of Revlon v. MacAndrews & Forbes Holdings, Inc. In Revlon, the Delaware Supreme Court held that in a sale of a company, the directors must exercise their fiduciary duties so as to achieve the highest price reasonably available. Plaintiffs were arguing, it seems, that the KFN board conducted neither an auction nor a market check, nor took any other action that would satisfy Revlon.

Ignoring whether the plaintiffs properly pleaded a Revlon claim, the Delaware Supreme Court said that it did not matter. First, Revlon was designed primarily for injunctive relief to be applied before closing of a transaction; the plaintiffs here were seeking post-closing relief. Second, and more important, when a merger transaction is approved by a fully informed, uncoerced vote of disinterested shareholders, the default business judgment rule applies even if there are process defects. These defects could include a failure to follow Revlon or the existence of interests of directors in the transaction that might have tainted the board's decision-making process. So long as there was full and fair disclosure to shareholders and an uncoerced vote, the defects will be overlooked. The opinion implies, but does not expressly state, that the principles of the case could apply even to a challenge brought prior to the vote. There is a caveat, however. The opinion does not apply to a transaction that is subject to an entire fairness review.

Corwin v. KKR provides clear recognition that having a substantial operational interest in a company does not necessarily equate to control, with its higher standards for M&A transaction process and procedure. Second, Revlon is not the be-all and end-all condition for immunizing a change-of-control transaction in Delaware. A board may be able to dispense with Revlon provided that it is fully candid with its shareholders about the proposed transaction and does not coerce the vote. Moreover, even conflicts of interest in the boardroom are not fatal, so long as they are carefully explained to shareholders, as implied by Section 144(a)(2) of the Delaware General Corporations Law. This is not to suggest that companies should lightly dispense with a more traditional approach of following Revlon and quarantining conflicts, but it is good to know that there may be a fallback when the exigencies of a transaction do not allow for best practice.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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