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In re KKR Fin. Holdings LLC Shareholder Litigation

Court of Chancery of Delaware, New Castle

October 14, 2014


Submitted July 29, 2014.

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[Copyrighted Material Omitted]

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Stuart M. Grant, Mary S. Thomas, Nathan A. Cook and Bernard C. Devieux of Grant & Eisenhofer P.A., Wilmington, Delaware; Mark Lebovitch, Jeroen van Kwawegen and Adam Hollander of Bernstein Litowitz Berger & Grossmann LLP, New York, New York; Christine S. Azar, Peter C. Wood, Jr. and Ned C. Weinberger of Labaton Sucharow LLP, Wilmington, Delaware; Christopher J. Keller, Eric J. Belfi and Michael W. Stocker of Labaton Sucharow LLP, New York, New York, Co-Lead Counsel for Plaintiffs.

Gregory P. Williams, Blake Rohrbacher and Susan M. Hannigan of Richards, Layton & Finger, P.A. of Wilmington, Delaware; Paul C. Curnin, Peter E. Kazanoff and Janet A. Gochman of Simpson Thacher & Bartlett LLP, New York, New York, Attorneys for Defendants KKR & Co. L.P., KKR Fund Holdings L.P., and Copal Merger Sub LLC.

Collins J. Seitz, Jr., Garrett B. Moritz and Eric D. Selden of Seitz Ross Aronstam & Moritz LLP, Wilmington, Delaware; William Savitt, Ryan A. McLeod and David Zhou of Wachtell, Lipton, Rosen & Katz, New York, New York, Attorneys for Defendants Tracy Collins, Robert L. Edwards, Craig J. Farr, Vincent Paul Finigan, Jr., Paul M. Hazen, R. Glenn Hubbard, Ross J. Kari, Ely L. Licht, Deborah H. McAneny, Scott C. Nuttall, Scott Ryles, Willy Strothotte, and KKR Financial Holdings LLC.


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This action involves the novel claim that a holder of less than one percent of the stock of a Delaware corporation was a controlling stockholder and thus owed fiduciary obligations to the other stockholders of the corporation.

In April 2004, KKR & Co. L.P. (" KKR" ) acquired KKR Financial Holdings LLC (" KFN" ) in a stock-for-stock merger involving two widely-held, publicly-traded companies. Seeking to overcome the presumption that business judgment review would apply to such a transaction, plaintiffs argue that entire fairness should apply because KKR was a controlling stockholder of KFN despite its less than one percent ownership and because a majority of the twelve members of the KFN board that approved the merger was beholden to and not independent from KKR.

Plaintiffs' controlling stockholder theory is based on the terms of a management agreement whereby an affiliate of KKR managed the day-to-day business of KFN, making KFN operationally dependent on KKR. Since KFN's inception, however, the ultimate authority for managing its business and affairs, including the decision whether to approve a merger with KKR, was in the hands of a board of directors subject to annual stockholder election.

In this opinion, I conclude that, although the allegations of the complaint demonstrate that KKR's affiliate managed the day-to-day operations of KFN, they do not support a reasonable inference that KKR controlled the board of KFN when it approved the merger, which is the operative question under Delaware law for determining whether a stockholder is controlling in this case. For this reason, I dismiss plaintiffs' fiduciary duty claim against KKR premised on the theory that KKR was a controlling stockholder of KFN.

I also conclude that plaintiffs' fiduciary duty claim against the directors of KFN fails to state a claim for relief because the board's approval of the merger is subject to business judgment review for two independent reasons. First, plaintiffs have failed to allege facts from which it is reasonably inferable that a majority of the KFN board was not disinterested in the transaction or independent from KKR. Second, even if plaintiffs had alleged sufficient facts to reasonably support such an inference, business judgment review still would apply because the merger was approved by a majority of disinterested stockholders in a fully-informed vote.

For these reasons, and others stated below, this action is dismissed with prejudice under Rule 12(b)(6) for failure to state a claim for relief.

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A. The Parties

Plaintiffs Pompano Beach Police & Firefighters' Retirement System, Robert A. Corwin, Eric Greene, Margaret DeMauro and Pipefitters Local Union No. 120 Pension Fund were stockholders of KFN who owned shares of KFN at all times relevant to this action.

Defendant KKR, a Delaware limited liability partnership, is a private equity firm based in New York that specializes in leveraged buyouts. The company was founded in 1976. Today it is a multinational investment firm. KKR completed an initial public offering on July 15, 2010, and its common stock trades under the ticker symbol " KKR" on the New York Stock Exchange.

Defendant KFN, a Delaware limited liability company, was a specialty finance company whose business was generating income and capital appreciation, primarily through investing in sub-investment grade corporate debt securities.

Defendants Tracy Collins, Robert L. Edwards, Craig J. Farr, Vincent Paul Finigan, Jr., Paul M. Hazen, R. Glenn Hubbard, Ross J. Kari, Ely L. Licht, Deborah H. McAneny, Scott C. Nuttall, Scott Ryles, and Willy Strothotte (together, the " KFN board" ) were the twelve members of the KFN board of directors in December 2013, when the decision was made to merge with KKR.

Defendants KKR Fund Holdings L.P., an exempted limited partnership formed under the laws of the Cayman Islands (" Holdings" ), and Copal Merger Sub LLC, a Delaware limited liability company (" Copal" ), are wholly owned subsidiaries of KKR. They were parties to the merger agreement along with KKR and KFN.

B. The Formation of KKR Financial

In 2004, KKR formed KKR Financial Corp., a Maryland real estate investment trust (" KKR Financial" ). In June 2005, KKR Financial engaged in an initial public offering. The prospectus for that offering described KKR Financial as " a specialty finance company created to invest across multiple asset classes with the objective of achieving attractive leveraged risk-adjusted returns." [2]

The 2005 prospectus disclosed that KKR Financial would be " externally managed and advised by KKR Financial Advisors LLC, an affiliate of KKR, pursuant to a management agreement." [3] The prospectus describes the management agreement in detail.[4] The terms of the management agreement, as amended following the restructuring of KKR Financial into KFN, are described below.

C. The Restructuring of KKR Financial into KFN

In April 2007, KKR Financial announced a proposed restructuring whereby KKR

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Financial would be reincorporated as a subsidiary of KFN, a newly created entity. The transaction was subject to the approval of the stockholders of KKR Financial. The prospectus for the transaction (the " 2007 Prospectus" ) disclosed that KFN would " assume all obligations of KKR Financial Corp. under the management agreement," which would be amended and restated (hereafter, the " Management Agreement" ), and that the " economic terms of the amended and restated management agreement will not be changed." [5] KKR Financial's stockholders approved the restructuring, which became effective in May 2007.

D. The Management Agreement

Under the terms of the Management Agreement, KFN delegated responsibility for its day-to-day operations to KKR Financial Advisors LLC (" KFA" or the " Manager" ), the same affiliate of KKR that had served as the manager of KFN's predecessor:

(b) . . . The Manager will be responsible for the day-to-day operations of the Company and will perform (or cause to be performed) such services and activities relating to the assets and operations of the Company as may be appropriate, including, without limitation: . . .
* * *
(vii) providing executive and administrative personnel, office space and office services required in rendering services to the Company;
(viii) administering the day-to-day operations of the Company and performing and supervising the performance of such other administrative functions necessary in the management of the Company as may be agreed upon by the Manager and the Board of Directors . . . .[6]

Plaintiffs' complaint quotes public filings of KFN describing its dependence on KFA as a result of the Management Agreement:

We are highly dependent on our Manager and may not find a suitable replacement if our Manager terminates the Management Agreement.
We have no employees . . . We have no separate facilities and are completely reliant on our Manager, which has significant discretion as to the implementation and execution of our business and investment strategies and our risk management practices.[7]

Similar disclosures were made in the 2007 Prospectus, when KFN was created to replace KKR Financial.[8]

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According to plaintiffs, the Management Agreement made KFA responsible for, among other things, " (i) selecting, purchasing and selling KFN's investments; (ii) KFN's financing and risk management; and (iii) providing investment advisory services to KFN." [9] Plaintiffs also allege that KFN was reliant on KKR to value its assets.

KFN's primary asset was a portfolio of subordinated notes in collateralized loan transactions that financed the leveraged buyout activities of KKR. The vast majority of KFN's holdings and liabilities were " Level 2" and " Level 3" assets, meaning that there were no observable market prices for those holdings and liabilities. KFN valued those assets and liabilities by applying a valuation model, which relied on inputs, estimations and judgments that KKR supplied and controlled.

In exchange for the services they provided, KKR and its affiliates were entitled to receive from KFN a base management fee equal to one-twelfth of KFN's equity multiplied by 1.75%, certain incentive compensation based on a complex formula and reimbursement of certain expenses. These fees (without expenses) equated to $60.5 million and $65.8 million, respectively in 2011 and 2012.

The Management Agreement renewed automatically each year by its own terms. KFN and its stockholders could terminate the Management Agreement under certain circumstances. According to plaintiffs, " they can do so only under certain conditions, generally with nearly six months advance notice, and with a Termination Fee of four times the sum of the average annual base management and incentive fee for the two years preceding termination." [10] Plaintiffs allege that, if the Management Agreement was terminated without cause on December 31, 2012, KFN would have been required to pay KKR approximately $252.6 million, which exceeded the amount of cash and cash equivalents on its balance sheet at that time (approximately $221.9 million).

Notwithstanding KFN's reliance on KFA to manage KFN's day-to-day operations, the Management Agreement explicitly provided that KFA would be subject to the supervision of KFN's board of directors:

The Manager, in its capacity as manager of the assets and the day-to-day operations of the Company, at all times will be subject to the supervision of the Company's Board of Directors and will have only such functions and authority as the Company may delegate to it including, without limitation, the functions and authority identified herein and delegated to the Manager hereby.[11]

More broadly, the Amended and Restated Operating Agreement of KFN (the " LLC Agreement" ), the original version of which was disclosed publicly as part of the 2007 Prospectus, empowers KFN's board of directors using language similar to Section 141(a) of the Delaware General Corporation Law. It provides that, except as otherwise provided in the LLC Agreement, " the business and affairs of [KFN] shall be managed by or under the direction of its

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Board of Directors." [12]

E. The Merger Negotiations

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