Delaware and the Myopic Nature of a "Neutral" Board: In re KKR Financial Holdings
The business judgment rule represents an over-inclusive protection designed to protect risk taking by directors. Boards know that even if they take risks that in hindsight prove to be mistaken and harmful, they will escape liability. The presumption is not, however, designed to protect decisions arguably motivated by a conflict of interest. The judicial erosion of fiduciary duties by the Delaware courts was on display in In re KKR Financial Holdings.
In that case, KKR formed KKR Financial Corp., a Maryland real estate investment trust. The "primary asset [of KFN] was a portfolio of subordinated notes in collateralized loan transactions that financed the leveraged buyout activities of KKR." The duties of KKR Financial were ultimately assumed by KFN. KFN in turn assigned the day to day management duties to KKR Financial Advisors LLC. KKR, however, owned less than 1% of the shares of KFN. Moreover, the operating agreement for KFN provided that "the business and affairs of [KFN] shall be managed by or under the direction of its Board of Directors." The board of KFN contained 12 directors, two of whom were described as "high-level KKR employees".
Ultimately, KKR sought to purchase KFN. The board formed a "transaction committee" After back and forth negotiations, the committee recommended approval of the merger. The board met and, with the two "high level KKR employees" excluded, voted to approve the merger.
Plaintiffs challenged the transaction and argued that KKR "controlled" KFN. As a result, the applicable standard of review should be entire fairness. In rejecting that assertion, the court had this to say:
- In my opinion, the allegations of the complaint do not support a reasonable inference that KKR was a controlling stockholder of KFN within the meaning of this Court’s precedents. Although these allegations demonstrate that KKR, through its affiliate, managed the day-to-day operations of KFN, they do not support a reasonable inference that KKR controlled the KFN board—which is the operative question under Delaware law—such that the directors of KFN could not freely exercise their judgment in determining whether or not to approve and recommend to the stockholders a merger with KKR.
The analysis was no surprise. While REITS are typically dependent upon their advisor, KFN carefully preserved the legal authority of the board to oversee the activities of the advisor. Moreover, with less than 1% of the shares, KKR did not have the ability to legally control the board.
What the court ignored, however, was the presence of a potential conflict of interest within the board room. The board of KFN excluded from approval of the merger the two KKR employees. Nonetheless, the court noted that, based upon plaintiff’s allegations, it was “reasonably conceivable that two other directors . . . would not be found independent of KKR.” One had “longstanding ties to KKR and, among other things, served as a Senior Advisor to KKR and as Chairman of KKR affiliate . . . at the time of the merger.” The other was the dean of a business school “which recently received a $100 million donation from KKR co-founder Kravis, an alumnus.”
The court went on to determine whether a majority of the board lacked independence and concluded that it did not. As the court determined: “I conclude that plaintiffs have failed to allege facts that support a reasonable inference that eight of the twelve KFN directors, constituting eight of the ten who voted on the transaction, were not independent from KKR. Thus, plaintiffs have failed to rebut the presumption that the business judgment rule applies to the KFN board’s decision to approve the merger.”
In other words, as has been discussed before (see Returning Fairness to Executive Compensation) the Delaware courts have created the fiction that boards with a majority of independent directors essentially expunge the taint of any conflict that arises from the presence of directors who are interested or lacking in independence. Having expunged the taint, the applicable standard becomes the all but impenetrable duty of care and the business judgment rule.
The approach is inconsistent with the theory behind the business judgment rule. As discussed in Returning Fairness:
- The business judgment rule represents an over-inclusive protection designed to protect risk taking by directors. Boards know that even if they take risks that prove in hindsight to be mistaken and harmful, they will escape liability. The presumption is not, however, designed to protect decisions motivated by a conflict of interest.
Where potential conflicts of interest exist in the decision making process, which is when there are directors participating in the debate and voting on the final resolution who are arguably interested or not independent, the application of the business judgment rule and a presumption of fairness is inappropriate. In those circumstances, the presumption may be protecting risk taking or it may be protecting a decision influenced or motivated by the interests of the directors allegedly lacking in independence.
Yet in Delaware that ship has sailed. It is so well established that boards get the presumption of the business judgment rule so long as they have a majority of disinterested and independent directors that the matter was not even discussed in In re KKR.