Structuring Take-Private Transactions Involving Controlling Stockholders in Light of Recent Delaware Percedent

© 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
jschreiber@winston.com
Chair, West Coast Private Equity
Los Angeles
+1 (213) 615-1719
evadavis@winston.com
Eva Davis John E. Schreiber
2

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
3

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.
4

• 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
5

• 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)
6

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.
7

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.
8

• 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.
9

• 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.
10

• 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.
11

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”)
13

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
14

• 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.
15

• 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.
16

• 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.
17

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
18

• 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.
19

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?
20

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.
21

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).
22

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.
24
Litigation Takeaways

Questions?
Litigation Partner
Los Angeles New York
+1 (213) 615-1850 +1 (212) 294-6850
jschreiber@winston.com
Chair, West Coast Private Equity
Los Angeles
+1 (213) 615-1719
evadavis@winston.com
Eva Davis John E. Schreiber
25

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Structuring Take-Private Transactions Involving Controlling Stockholders in Light of Recent Delaware Percedent

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