This article was published on January 7, 2015 in Delaware Business Court Insider. It is reprinted here with permission.
In just the past three months, the Delaware Court of Chancery has issued four opinions (In re KKR Financial Holdings LLC Shareholder Litigation, Consol. C.A. No. 9210-CB; In re Crimson Exploration Stockholder Litigation, C.A. No. 8541-VCP; In re Sanchez Energy Derivative Litigation, Consol. C.A. No. 9132-VG; and In re Zhongpin Stockholders Litigation, Consol. C.A. No. 7393-VCN) addressing the circumstances in which a minority stockholder may be deemed a controlling stockholder under Delaware law.
It is well settled that a stockholder is deemed to be a "controlling" stockholder only where: (1) it owns more than 50 percent of the voting power of a corporation, or (2) it exercises actual control over the corporation's board of directors. The above referenced opinions, which are discussed below, provide valuable guidance as to the circumstances under which minority stockholders may be deemed a controller under the second part of this test. Specifically, the cases make clear that actual board control in the transaction at issue is the "defining and necessary feature of a minority controlling stockholder."
In re KKR
On Oct. 14, 2014, in KKR, Chancellor Andre G. Bouchard held that the plaintiffs failed to adequately plead that KKR & Co. LP, a 1 percent stockholder of KKR Financial Holdings LLC (KFN), was a controlling stockholder under Delaware law, despite demonstrating that KKR actively managed and controlled KFN's day-to-day operations. The suit arose out of defendant KKR's acquisition of KFN through a stock-for-stock merger. In an effort to overcome the business judgment rule and trigger entire fairness review, the plaintiffs alleged that KKR was a controlling stockholder of KFN and stood on both sides of the challenged transaction. In support of their contention that KKR was a controlling stockholder, the plaintiffs relied primarily on allegations that, under the terms of a management agreement between KFN and one of KKR's affiliates, KFN delegated complete responsibility over its day-to-day operations to KKR's affiliate management company. The plaintiffs also alleged that KKR created KFN, all of KFN's officers were employed by KKR and its affiliates, KFN was completely reliant on KKR, and KFN's primary asset existed to support KKR's operations.
The court found that although the plaintiffs' allegations demonstrated that KKR "managed the day-to-day operations of KFN," the allegations did "not support a reasonable inference that KKR controlled the KFN board," which the court made clear "is the operative question under Delaware law" for determining whether a minority stockholder is a controller. Indeed, the court noted that KKR owned less than 1 percent of KFN's stock, and therefore did not possess sufficient voting power to remove directors from their positions; KKR did not have a right to appoint directors, much less a majority; and KKR did not have any right to dictate or veto board action. For these reasons, the court held that the plaintiffs' allegations "do not support a reasonable inference that KKR was a controlling stockholder of KFN."
In re Crimson
On Oct. 24, 2014, just 10 days after Bouchard decided KKR, Vice Chancellor Donald F. Parsons Jr. decided Crimson, in which he analyzed, but ultimately did not decide, whether the plaintiffs adequately alleged that Oaktree Capital Management and its affiliates, a stockholder group comprising 33.7 percent ownership of Crimson Exploration Inc., constituted a controller. The suit arose out of a merger between Crimson and a third-party company, pursuant to which the Crimson stockholders were paid approximately $3.19 for each share of their stock. The plaintiffs alleged that Oaktree was a controlling stockholder of Crimson and breached its fiduciary duties by selling the company below market value for self-serving reasons. In support of their contention that Oaktree was a controlling stockholder of Crimson, the plaintiffs alleged that Oaktree controlled over one-third of the voting control of Crimson; Oaktree was one of Crimson's largest creditors, if not the largest creditor; Oaktree designated a majority of the directors and senior management; and three of the seven directors worked for Oaktree.
Although not affirmatively deciding the issue, and instead dismissing the suit on other grounds, the court expressed skepticism about whether the plaintiffs' allegations sufficiently alleged that Oaktree controlled Crimson. Indeed, Parsons explained that the plaintiffs failed to plead "specific allegations" from which a court could reasonably infer that Oaktree "actually exercised control over Crimson or the negotiation of the merger," and that it was accordingly hesitant to find that the plaintiffs met their pleading burden. Although the plaintiffs appeared to plead facts showing Oaktree's potential ability to control Crimson, the plaintiffs failed to plead specific facts demonstrating that Oaktree used that potential ability to actually control the challenged board action.
In re Sanchez
In Sanchez, decided Nov. 25, 2014, Vice Chancellor Sam Glasscock III, citing Bouchard's decision in KKR and Parsons' decision in Crimson, held that the plaintiffs failed to sufficiently plead that A.R. Sanchez Jr. and A.R. Sanchez III, co-founders of Sanchez Energy Corp. and owners of 21.5 percent of Sanchez Energy's stock, together constituted a controlling stockholder under Delaware law. The stockholder plaintiffs in Sanchez brought suit asserting derivative claims on behalf of Sanchez Energy, challenging a transaction by which Sanchez Energy acquired assets from a related entity. The plaintiffs alleged, among other things, that Sanchez Jr. and Sanchez III were controlling stockholders of Sanchez Energy and that they stood on both sides of the transaction, thereby triggering entire fairness review. In support of their contention that Sanchez Jr. and Sanchez III were controlling stockholders, the plaintiffs primarily alleged that Sanchez Jr. and Sanchez III own a combined 21.5 percent stake of Sanchez Energy, and that Sanchez III, as Sanchez Energy's CEO, had the authority to, and in fact did, direct management of the company and the company's day-to-day operations.
As the court pointed out, the plaintiffs did not allege "that Sanchez III exercise[d] greater control than that typical of a CEO, that he dominate[d] or control[led] the board, or that he ha[d] even attempted to dominate the board through threats, bullying, or the like." Because the plaintiffs "allege[d] that the Sanchez family ha[d] managerial control, but not board control, of the company," the court found that the plaintiffs' complaint did not give rise to "a reasonable inference that Sanchez Jr. and Sanchez III, individually or in the aggregate, [were] controlling stockholders" of Sanchez Energy and actually controlled the company's board in the challenged transaction.
In re Zhongpin
On Nov. 26, 2014, just one day after the court decided Sanchez, it once again analyzed whether a minority stockholder constituted a controller under Delaware law in Zhongpin. On the court's fourth occasion analyzing this issue in a little more than two months, Vice Chancellor John W. Noble found that the plaintiffs adequately alleged that defendant Xianfu Zhu, a 17.3 percent stockholder of Zhongpin Inc., actually controlled Zhongpin's board such that it was conceivable that Zhu was a controller. The plaintiffs in Zhongpin, former stockholders of Zhongpin, brought suit challenging a going-private transaction, in which defendant Zhu acquired all of the company's outstanding stock. The plaintiffs challenged the fairness of the merger, and alleged that Zhu was a controlling stockholder and stood on both sides of the challenged transaction, accordingly triggering entire fairness review.
To show that Zhu controlled Zhongpin's board, the plaintiffs relied primarily on statements made in Zhongpin's annual 10-K, which conceded that Zhu, in addition to being Zhongpin's largest stockholder, was Zhongpin's founder, chairman of the board and chief executive officer, and as such, "ha[d] significant influence over [Zhongpin's] management and affairs and could exercise [that] influence against" the interests of the other Zhongpin stockholders. The plaintiffs also alleged that Zhu exercised the influence he had to commandeer the board into accepting his offer to purchase Zhongpin's common stock for $13.50 per share. Indeed, the complaint alleged that despite that Zhongpin received an indication of interest for $15 per share from an unaffiliated third-party bidder, and even though Barclays, Zhongpin's financial adviser, refused to render an opinion as to the fairness of the $13.50 per-share price offered by Zhu, the board accepted Zhu's offer in large part because Zhu told the board that its continued delay in accepting his offer would jeopardize Zhu's financing for the deal, and accordingly his ability to close on his offer.
The court, after explaining that "actual control over business affairs [of the corporation] may stem from sources extraneous to stock ownership," concluded that the plaintiffs' allegations supported reasonable inferences that Zhu actually controlled the board. The court reasoned that "despite the fact that Zhu's ownership interest was much smaller than a typical controller's, plaintiffs plead indicia of domination, sufficient to raise an inference that Zhu exercised control over Zhongpin," and therefore denied the defendants' motion to dismiss the complaint.
These cases make clear that a stockholder will only be considered a controller if the stockholder actually controls or dictates the challenged board action. As confirmed in KKR and Sanchez, a stockholder may influence or assert control over the company's non-director management and day-to-day operations without being deemed a controlling stockholder. As Crimson illustrates, a minority stockholder may even possess or accumulate the power to influence or control board action, so long as the stockholder does not actually use that power to control the challenged board conduct. Indeed, merely having the power to dictate board action, without more, is not sufficient to render a minority stockholder a controller under Delaware law. With that said, the court in Zhongpin showed that analyzing whether the minority stockholder actually controlled the challenged board action will be determined on a case-by-case basis and may be demonstrated in a variety of ways, many of which may be unrelated to stock ownership or voting control.
Although minority stockholders who wish to avoid being deemed a controlling stockholder under Delaware law may exert control over non-director management and the company's day-to-day operations as well as accumulate or possess the power to control the board, such minority stockholders, in order to avoid being deemed a controller, must not take action intended to influence the board's decision-making process. A minority stockholder who has the power to control the board and uses that power to dictate the challenged board action will be deemed a controlling stockholder under Delaware law.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.