In a recent decision, Chief Justice Strine, writing for the Delaware Supreme Court, sitting en banc, provided guidance on the proper application of Revlon and the limitations in the court’s power to issue a mandatory injunction, holding that: (i) under Revlon, a board of directors had wide latitude in crafting a change-of-control process; and (ii) even if a court found that the board did not fulfill its fiduciary duty in a change of control, the court could not “blue-pencil” the merger agreement in a way that reduced a third party’s rights absent wrongdoing on the part of such third party.1
C&J Energy Services, Inc. (C&J), a Delaware corporation, entered into an agreement to acquire a division of Nabors Industries Ltd. (Nabors), which was based in Bermuda. The transaction was structured as an “inversion” with the surviving entity domiciled in Bermuda for tax-saving purposes, and, as a result, Nabors would hold a majority of the equity in the surviving entity even though C&J was the nominal buyer.
To counter the effect of Nabors’ majority control post-closing, the transaction included several unusual features. For example, C&J insisted on several corporate governance protections, including providing in the by-laws that all stockholders would share pro rata in a future sale of the surviving entity, which provision could not be repealed without unanimous stockholder approval; requiring a two-thirds vote to amend corporate by-laws, sell the company, or issue stock for a period of five years; and restricting Nabors from acquiring additional shares or selling its shares for five years. Further, C&J, as the buyer, negotiated for a “fiduciary out” in the merger agreement that would allow it to terminate the transaction in favor of a superior proposal after a lengthy passive market check (the agreement was announced on July 25 and expected to close near the end of the year, giving time for a serious bidder to emerge) and a relatively modest termination fee representing 2.27 percent of the deal value. The transaction was approved by C&J’s board of directors, which had five independent directors among its seven members.
C&J’s stockholders filed a class action suit to enjoin the merger, alleging: (i) a breach of fiduciary duty under Revlon by the C&J board for approaching the transaction as an acquisition of Nabors rather than a sale of control of C&J and failing to affirmatively shop the company before or after the signing; (ii) a breach of the duty of loyalty by the CEO and chairman who was self-interested in getting a better compensation package and failed to keep the board adequately informed of the negotiations; and (iii) a conflict of interest on the part of C&J’s banker, Citi Global Markets Inc.
Although the Court of Chancery found that the C&J board was fully informed and there was no evidence that the CEO breached his duty of loyalty, it concluded that there was a “plausible showing of a likelihood of success” on the merits on a claim that the C&J board breached its fiduciary duty because the transaction involved a change in control and the board “did not approach [it] as a part of a sales effort.” The Court of Chancery granted a preliminary injunction to delay the stockholder vote for 30 days and required C&J to shop itself and solicit other proposals. Although the merger agreement contained a “no shop” provision, the Court of Chancery ordered that solicitation by C&J during the injunction period would not constitute a breach of the merger agreement.
Plaintiffs Seeking a Mandatory Injunction Must Prove a Reasonable Likelihood of Success on the Merits
To obtain a preliminary injunction, the stockholders must demonstrate: (i) a reasonable probability of success on the merits, (ii) an irreparable injury without an injunction, and (iii) the harm without an injunction outweighed the harm to other parties resulting from the injunction. Moreover, in order to enjoin a corporate transaction, the showing of a reasonable probability of success must be “particularly strong” when no other bidder had emerged. The Court of Chancery’s opinion, however, acknowledged that the question on the breach of fiduciary duty by the C&J board was “too close to call,” outlined substantial arguments against granting the injunction, and highlighted that no rival bidders had emerged in the market-check period. Based on the record, the Delaware Supreme Court found that the Court of Chancery did not apply the appropriate standard of review and erred in granting the preliminary injunction when it only found a “plausible showing of likelihood of success” on the merits. The Supreme Court found that C&J’s stockholders did not meet the burden of proof in demonstrating that they would prove that they were “more likely than not to be entitled to relief.”
The Board Was Entitled to Business Judgment in Crafting a Change-of-Control Process
Furthermore, the Supreme Court found that the Court of Chancery also misapplied the Revlon doctrine by requiring a company to shop itself in a change-of-control transaction to fulfill its fiduciary duty to seek the highest immediate value.2 The Supreme Court held that Revlon permitted a board to “pursue a transaction it reasonably view[ed] as most valuable to stockholders, so long as the transaction [was] subject to an effective market check” and the stockholders were given a fully informed, uncoerced opportunity to vote on the deal. Revlon did not require a board to follow a prescribed sales process to fulfill its duties or for it to run an auction whenever there was a change-of-control transaction.
On the contrary, an independent and well-informed board, as the one in C&J, was entitled to use its business judgment in determining the process through which to evaluate and approve such transaction. Further, an active “go shop” was not the only means for an effective market check. Under Revlon and its progeny, an effective market check could be met so long as other bidders had a fair opportunity to present a higher-value alternative, and the board had the flexibility to accept the more favorable deal. The Supreme Court found no material barriers that would have prevented a superior offer because the C&J board had a “fiduciary out” under the merger agreement and there was sufficient time in the lengthy market check to allow a serious bidder to present its offer. The Supreme Court also noted the fact that C&J’s stockholders were presented with the information regarding the benefits and risks of the transaction and could vote to reject the merger if they did not agree with the board’s judgment.
The Chancery Court Cannot Use Its Equitable Powers to Strip Innocent Third Parties of Contractual Rights
The Supreme Court found that the Court of Chancery erred in issuing a mandatory preliminary injunction requiring C&J to engage in a “go shop” process and blue-penciling the merger agreement to strip Nabors of its right to walk away under the “no shop” provision. The Supreme Court held that a mandatory preliminary injunction must be based on findings of fact after a trial or solely on undisputed facts. Here, there were a number of important factual disputes and the Court of Chancery had found only a “plausible” merits case. Further, the traditional use of a preliminary injunction was to preserve the status quo, not to divest third parties of their contractual rights.
The Supreme Court also found that it was improper for the Court of Chancery to have stipulated that the court-required active solicitation by C&J would not constitute a breach of the merger agreement. The Supreme Court ruled that this type of judicially ordered infringement of contractual rights “should only be undertaken on the basis that the party ordered to perform was fairly required to do so, because it had, for example, aided and abetted a breach of fiduciary duty.” Here, C&J’s stockholders only made a cursory mention of Nabors’ alleged aiding-and- abetting liability and there were no findings of any bad act by Nabors. The Supreme Court held that Delaware chancery courts may not use their equitable powers to blue-pencil an agreement to excise a provision beneficial to an innocent third party, but at the same time “declare that the third party could not regard the excision as a basis for relieving it of its own contractual duties.”
This case made clear once again that there was “no single blueprint that a board must follow to fulfill its Revlon duties.” Chief Justice Strine explained that “Revlon made clear that when a board engages in a change-of-control transaction it must not take actions inconsistent with achieving the highest immediate value reasonably attainable.” However, Chief Justice Strine held in this case that, “when a board exercises its judgment in good faith, tests the transaction through a viable passive market check and gives its stockholders a fully informed, uncoerced opportunity to vote to accept the deal, we cannot conclude that the board likely violated its Revlon duties.” This strong affirmance of the board’s business judgment in determining the best course of action to maximize shareholder value is welcome news to boards seeking to fulfill their duties to stockholders. Moreover, the Delaware Supreme Court clarified that “although the equitable authority of our Court of Chancery is broad, it is not uncabined.” It is helpful for buyers and sellers to know that absent wrongdoing, the agreements they enter into will be enforced by Delaware courts.