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© 2015 Winston & Strawn LLP

Structuring Take-Private Transactions Involving Controlling Stockholders in Light

of Recent Delaware Precedent

July 21, 2015


Today’s Speakers

Litigation Partner Los Angeles New York +1 (213) 615-1850 +1 (212) 294-6850 [email protected]

Chair, West Coast Private Equity Los Angeles +1 (213) 615-1719 [email protected]

Eva Davis John E. Schreiber

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mailto:[email protected]



Take-Private Transactions Involving Controlling Stockholders – By the Numbers

• In 2013-2014, 66 take-private transactions closed, valued at a total of $103.2 billion.

• Source: S&P's Capital IQ

• Over that same period, approximately 94% of all M&A deals valued over $100 million were litigated.

• Source: Cornerstone Research

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Legal Challenges to Take-Private Transactions Involving Controlling Stockholders – Breach of Fiduciary Duty • Two fiduciary duties: care and loyalty

• Duty of care requires fiduciaries to exercise the “care which ordinarily careful and prudent men would use in similar circumstances.” • Fiduciaries must act on an informed basis after considering relevant information,

including the input of financial and legal experts.

• Duty of loyalty obligates fiduciaries to act in “good faith” and refrain from putting his or her interests ahead of the corporation. • A plaintiff can challenge a fiduciary’s loyalty by demonstrating that he or she (i) was

interested in the transaction under consideration or not independent of someone who was, or (ii) failed to pursue the best interests of the corporation and its stockholders and therefore failed to act in good faith.

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Legal Challenges to Take-Private Transactions Involving Controlling Stockholders – Breach of Fiduciary Duty • Standard of Review: Business Judgment Rule vs. Entire Fairness

• Business judgment rule – default standard • Has been characterized as a “principle of non-review that reflects and promotes the

role of the board of directors as the proper body to manage the business and affairs of the corporation.”

• Presumes that, in reaching a business decision, directors are informed, operating in good faith, and believe that the “action taken was in the best interests of the company.”

• Under this forgiving standard, a business decision must “lack[] any rationally conceivable basis” for a court to “infer bad faith and a breach of duty.”

• Entire Fairness Standard – until recently, applied in all controlling stockholder (or other “interested”) transactions • Burden of proof lies with defendants to demonstrate that transaction was “entirely

fair” – i.e., that it mirrored an arm’s-length negotiated transaction.

• Standard has two components: fair dealing and fair price

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Legal Challenges to Take-Private Transactions Involving Controlling Stockholders – Breach of Fiduciary Duty

• Burden shifting in cases governed by entire fairness standard

• Defendants may shift burden of proof to plaintiff by showing that the transaction was approved by either: (1) a well-functioning committee of independent directors; or

(2) an informed vote of a majority of the minority stockholders (“majority of the minority” provision)

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Lessons Learned from Controlling Stockholder Take-Private Transactions in 2014

• In 2014, the Delaware courts issued several key decisions – perhaps the most important to date – concerning the legal standards governing going-private transactions involving controlling stockholders.

• Taken together, these cases: (1) underscore the fact-intensive nature of establishing whether and under what circumstances a minority equity stake in a corporation may be deemed a controlling one; and

(2) provide a roadmap to obtaining the deferential business judgment standard of review, rather than entire fairness standard, when engaging in controlling stockholder transactions.

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Controlling Stockholder Take-Private Litigation in 2014

• Business Judgment Rule Applies to Certain Controlling Stockholder Deals

• In re MFW Shareholders Litigation, 67 A.3d 496 Del. Ch. May 29, 2013), affirmed Kahn v. M&F Worldwide Corp., No. 334, 2013 (Del. Mar. 14, 2014)

• MacAndrews and Forbes (“M&F”) was the controlling stockholder (43%) of M&F Worldwide (“MFW”) and offered to purchase the rest of MWF’s outstanding equity for $24 per share.

• MFW’s shares were trading at $16.96 at the close of the last business day prior to M&F’s offer.

• Shareholders brought suit challenging the merger alleging that it was unfair and sought a post-closing damages remedy for breach of fiduciary duty.

• At the outset, M&F conditioned consummating any going-private transaction upon the transaction being approved by (i) an independent special committee and (ii) a vote of a majority of the disinterested stockholders.

• The Court of Chancery held that the appropriate standard of review was the business judgment rule and granted judgment in the in favor of the defendants.

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• Delaware Supreme Court affirmed that controller-led take-private transactions are subject to review under business judgment standard when they are conditioned – from the outset – on the approval of both:

(i) a fully-empowered, disinterested and independent special committee, and

(ii) a fully-informed and uncoerced majority-of-the-minority vote.

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• Entire Fairness Review Still Applies to Certain Controlling Stockholder Deals • In re Orchard Enterprises, Inc. Stockholder Litigation, C.A. No. 7840 (Del. Ch.

Feb. 28, 2014)

• The controlling stockholder, Dimensional Associates, LLC (“DA”) held 53% of the voting power of Orchard.

• In October 2009, DA offered to buy out Orchard’s minority stockholders for $1.68 per share in cash.

• Orchard formed a five-member special committee, which was authorized to negotiate with DA and potential third-party bidders and to hire independent legal and financial advisors.

• Orchard’s public announcement of DA’s initial proposal led to a higher offer from a third party. DA then offered $2.10 per share without a majority-of-the-minority approval condition, and finally agreed on a price of $2.05 per share with a go-shop and a majority-of-the-minority condition.

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• The financial advisor issued an opinion that the $2.05 per share price was fair from a financial point of view (taking into account that $25 million of the equity value of Orchard would be allocated to the Series A Preferred Stock).

• Orchard’s proxy statement recommended approval of the merger and in July 2010, holders of a majority of the minority approved the merger.

• The Court held that the appropriate standard of review was the entire fairness standard because the controlling stockholder did not agree up-front that the deal would be conditioned upon approval by a special committee and a majority vote of the minority stockholders.

• No burden shifting either because defendants did not establish as a matter of law – as required at summary judgment stage – that the majority-of-the-minority vote was fully-informed or that the special committee was disinterested and independent.

• Result of appraisal proceeding – $4.67 per share (more than double what DA paid) – not dispositive of “entire fairness” determination.

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Business Judgment Rule Applies (No Controlling Stockholder)

• KKR Financial Holdings LLC Stockholder Litigation (Del. Ch. October 14, 2014) • KKR Financial (KFN) board approved a $2.6 billion merger of KFN with PE Fund

KKR

• PE Fund KKR owned 1% of KFN

• PE Fund KKR’s affiliate managed the day-to-day operations of KFN under a management agreement

• $256 million early termination fee of management agreement severely limited KFN’s value, essentially making it a decision to sell to KKR or not to sell at all; no other buyers practical

• Merger price represented a 35% premium

• Court held that management agreement was not an agreement that controlled the decisions of the board of directors

• KKR could nominate directors but could NOT remove or appoint directors or block board decisions

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• Key question was not whether the stockholder exercised control over the company’s operations, but whether it exercised control over the decision to approve the merger.

• Alternative ground for application of BJR:

(i) Majority of the special committee was independent of KKR (even those nominated by KKR and having past business relationships); and

(ii) Merger approved by a majority of outstanding KFN shares, including a majority of shares not owned by KKR and its affiliates (“majority of the minority”)

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Business Judgment Rule Applies (No Controlling Stockholder)

• In re Crimson Exploration Stockholder Litigation (Del. Ch. October 24, 2014) • Crimson’s stock-for-stock merger with Contango Oil & Gas at small 7.7% premium

• PE Fund Oaktree owned 34% of Crimson and was a large creditor

• 3 of 7 directors were Oaktree employees

• Rejected that independent 15% shareholder should be aggregated with Oaktree to find a “control group” merely due to “concurrence of self interest” • Presumption that all shareholders, including controlling shareholders, want to maximize the

value of their shares

• To aggregate, court held there needed to be a legally significant actual agreement to work together toward a shared goal

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• Rejected that registration rights agreement or post-signing agreement by the buyer to prepay target debt at a 1% premium was a unique additional benefit to Oaktree that would make the deal a conflicted transaction

• Reviewed the outcomes in a string of cases with ownership percentages from 27% to 49% • Not a linear, sliding-scale approach to control findings: control found in a 35% shareholder

case but no control in 46% shareholder case

• Key inquiry: whether the less-than-50% holders actually control the board’s decisions about the challenged transaction

• If a control stockholder is not conflicted with respect to a challenged transaction, company directors will not be considered to lack independence solely based on their affiliation with the control stockholder

• Oaktree was found not to be a control stockholder; Even if a control stockholder, deal did not involve the type of controlling stockholder conflict that would trigger entire fairness review.

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• Entire Fairness Review May Apply to Private Equity Fund Take-Private

• Frank v Elgamal, C.A. No. 6120-VCN (Del. Ch. Mar. 10, 2014)

• Private equity fund Great Point Partners sought to acquire American Surgical Holdings, Inc. Four members of management of American Surgical owned a total of 68% of the Company’s stock, although no one individual owned more than 50%.

• The board formed a Special Committee of independent, non-executive directors and obtained a financial advisor to solicit offers. Three potential buyers, including Great Point, submitted offers.

• Special Committee oversaw the negotiation process for the sale of American Surgical Holdings, Inc. to Great Point.

• Great Point Partners presented the target with three choices with varying mixes of cash and equity to be provided to “rollover stockholders” (management).

• The option selected by the special committee provided the greatest ratio of cash to equity to the rollover stockholders but provided slightly less overall consideration to the minority stockholders (4 cents per share) than if the rollover stockholders took more equity.

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• Court concluded that “entire fairness” standard could apply. • Management stockholders and minority stockholders had a direct conflict of interest

• Issues of material fact as to whether the “rollover group” was a control group.

• Also unclear if the special committee was well functioning and fully informed.

• Procedural defect (no record in the minutes that special committee was informed of the varying levels of compensation to the minority stockholders)

• Key takeaways: • Be vigilant about addressing potential conflicts of interests, particularly those presented by

insider stockholders (like rollover management).

• Any option that deprives the minority stockholders with even a few pennies per share can lead to a lawsuit in which the burden lies on the board of directors to prove the merger was entirely fair.

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Entire Fairness Review Applies to CEO Take-Private

• In re Zhongpin Inc. Stockholders Litigation (Del. Ch. Nov. 26, 2014) • Founder, Chairman and CEO was determined to be controlling stockholder, even

though he owned only 17% of the company’s stock (largest stockholder)

• Unusual degree to which CEO was indispensable to the company as a practical matter precluded the special committee from functioning effectively (equivalent of CEO having actual control over the board): • Combination of factors not fully detailed in the opinion gave the CEO effective veto power over

sale of company

• Loss of CEO would have MAE on the company; only other bidder required CEO to continue in CEO role (which CEO was unwilling to do)

• Committee had no leverage to negotiate a higher price with CEO

• Committee had no ability to attract a competing bidder given CEO’s unwillingness to cooperate

• Initial investment banker refused to provide a fairness opinion at initial $13.75 per share deal price (and that banker ultimately resigned); new investment bankers provided a fairness opinion for a lower $13.50 deal price after CEO rejected their requests for a price increase and no competing bids

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• Only competing bid was at a higher $15.00 price (conditioned on CEO remaining as CEO)

• Plaintiff’s alleged that $13.50 per share represented a 42% discount to recent highs and was below even the low-end valuations

• Merger was not conditioned from the outset on an uncoerced, informed majority-of-the minority vote. Stockholder approval at only 51.3% level.

• Court denied motion to dismiss, concluding that the stockholder plaintiffs’ allegations sufficiently raised an inference that chairman and CEO could control the company – and, accordingly, that entire fairness rather than the business judgment review applied – notwithstanding the CEO’s mere 17% percent ownership stake. • CEO possessed both “latent” control (via his stock ownership) and “active” control (with respect

to the day-to-day operations) of Zhongpin.

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Deal Takeaways

Focus of analysis by the courts is on whether there is actual control by a stockholder – not just a numbers test, but a flexible, fact specific test.

• Did the intentions, actions, agreements and record throughout the deal process demonstrate that a stockholder had actual control over the board of directors in the subject transaction (and was thus a controlling stockholder)?

• Or, will the record of the deal process demonstrate that a stockholder took a backseat and allowed the board to function on its own without influence or interference from that stockholder?

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Deal Takeaways

Business Decision: Whether to build a record to demonstrate all of the following in order to obtain less stringent business judgment level of review:

1. The controlling stockholder conditions the transaction on both a special committee approval and a majority-of-the-minority vote of stockholders;

2. The special committee is independent;

3. The special committee is empowered to freely select its own advisors and definitively say “no” to the transaction;

4. The special committee fulfills its duty of care in negotiating a fair price;

5. The vote of the minority stockholders is informed; and 6. There is no coercion of the minority stockholders.

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Deal Takeaways

Practice Tip: While a controlling stockholder is not legally required to assist the company in obtaining competing bids, the controlling stockholder’s position in any subsequent plaintiff stockholders’ action will be significantly advantaged to the extent the controlling stockholder can demonstrate that it cooperated with the company’s sale process and negotiated with or was willing to participate with competing bidders. Whether to subject a transaction to a majority-of-the-minority condition is a crucial business decision to be made by any board of directors and to be offered from the outset by any controlling stockholder. • May lead to a higher price being paid to the minority stockholders or may put

the overall transaction at risk due to a failed stockholder vote (or delay as a higher price is negotiated in the face of an actual or threatened failed stockholder vote).

• As a practical matter, the critical decision may be whether to pay more now (in order to achieve a majority-of-the-minority approval) or pay more later (through the time and expense of protracted litigation under the entire fairness standard of review).

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Litigation Takeaways • In determining whether a stockholder is a controller, primary focus will be on

assessing the extent to which the alleged controller influenced the board’s decision with respect to the transaction at issue.

• Relevance of stockholder’s control over the company’s day-to-day operations?

• Given fact-specific nature of inquiry, dismissals at the pleading stage on this basis may be difficult to come by.

• Where transaction is deemed to involve a controlling stockholder, Delaware Courts have now provided a pathway for avoiding entire fairness review.

• Court of Chancery’s decisions in both MFW and Orchard viewed this exception – conditioning the transaction at the outset on approval by an independent special committee and a majority-of-the-minority vote – as a potential avenue for controllers and directors to dispose of squeeze-out litigation at the pleading stage (i.e., prior to discovery)

• Delaware Supreme Court signaled a very different vision in its affirmance in MFW.

• While the court blessed the advent of a mechanism by which controllers and target boards can secure business judgment protection in the freeze-out context, it also erected potential hurdles that could mitigate the benefits of constructing the procedural devices in the first instance.

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• The Supreme Court also stated that in order to avoid entire fairness, defendants are required to establish entitlement to business judgment protection – prior to trial, or be stuck with the entire fairness burden for the duration. • If, after discovery and summary judgment, “triable issues of fact remain about

whether either or both of the dual procedural protections were established, or if established were effective, the case will proceed to a trial in which the court will conduct an entire fairness review.”

• If followed to the letter, the holding would preclude business judgment protection in situations where it has been historically available.

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Litigation Takeaways


Questions?

Litigation Partner Los Angeles New York +1 (213) 615-1850 +1 (212) 294-6850 [email protected]

Chair, West Coast Private Equity Los Angeles +1 (213) 615-1719 [email protected]

Eva Davis John E. Schreiber

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