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Delaware Supreme Court Clarifies Ab Initio Requirement Under MFW

Latham & Watkins LLP

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USA May 2 2019

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Latham & Watkins Securities Litigation & Professional Liability

Practice

Under MFW

To obtain business judgment deference, controllers must insist on MFW’s minority

protections before engaging in any substantive economic or valuation discussions.

The Delaware Supreme Court’s 2014 decision in Kahn v. M&F Worldwide Corp.1 (MFW) altered the

landscape for suits challenging controlling stockholder take-private transactions. The decision provided

that if a controller conditions the deal on specific minority stockholder protections from the beginning, then

the transaction may be subject to the same deferential “business judgment†review that applies to arm’s-

length, third-party transactions under Delaware General Corporation Law § 251 (8 Del. C. § 251), rather

than the more stringent “entire fairness†standard.2 Questions that have arisen since MFW include: when

exactly is the “beginning†of a transaction and when does the beginning end? Deal discussions often

begin informally or proceed in an on-again, off-again manner, and prior case law was unclear about the

precise point in the process when the controller needed to insist upon MFW’s minority protections in order

for the transaction to obtain business judgment deference.

The Delaware Supreme Court’s April 5, 2019, decision in Olenik v. Lodzinski3 provides some much-

needed clarity to that timing issue. Earlier cases held that the MFW protections must be in place before

any “substantive economic negotiations†took place, but Lodzinski expands upon that standard and

explains that early exploratory discussions about ranges of value, or intentions to make future offers, may

trigger the need for the protections to be in place even if no firm offer is on the table at such time.

Controllers, target companies, and the targets’ special committees must be familiar with Lodzinski

because once substantive economic negotiations begin, it is probably too late to put the MFW protections

in place. Implementing the protections at the right time can be the difference between a pleadings stage

dismissal (under the business judgment standard) and a full trial (under the entire fairness standard that

otherwise applies to transactions with controllers).

Controlling Shareholder Buy-Out: The Road to MFW

Under Delaware law, a controlling stockholder’s buy-out of the company’s minority interests was

historically reviewed under the rigorous entire fairness standard given that controllers, by definition,

control the company and can impose their will over the objection of the minority. Even if a special

committee of disinterested directors approved the deal, or if the deal was subject to a vote of the minority

stockholders, the burden of proof would, at most, shift from the defendant to the plaintiff — and the

standard would still be whether the deal was “entirely fair†to the minority stockholders. Given the fact-

Latham & Watkins May 2, 2019 | Number 2493 | Page 2

specific nature of the fairness inquiry, if that standard applied, a pleadings-stage dismissal was very

unlikely. The law therefore provided little incentive for controllers to condition deals on minority

stockholder protections, because even if they did, they would likely either have to pay to settle claims

challenging the transaction’s fairness, or undergo extensive litigation and potentially a full trial to prove

the fairness of the deal.4 The unfortunate consequences of this state of law were that (i) no matter how

favorable the deal was for minority stockholders, the deal would likely trigger litigation, and (ii) every such

suit carried automatic settlement value.

The law changed with MFW and its progeny. In MFW, the Delaware Supreme Court reasoned that a

controller could mirror a third-party, arm’s-length merger under 8 Del. C. § 251 by irrevocably subjecting a

transaction to two specific minority protections from the outset of the negotiations: (i) an empowered,

independent special committee;5 and (ii) the informed, uncoerced consent of a majority-of-the-minority

stockholders.6 The Court reasoned that if these conditions were in place ab initio, the controller would

have sufficiently “disabled†itself from unfairly influencing the transaction. With the removal of the

controller’s thumb from the scale, minority stockholders would have the same general protections as

stockholders in a third-party merger offer. Thus, the Court saw no reason why a transaction with a

properly disabled controller should be treated any differently than a third-party deal, and therefore

concluded that, if MFW’s conditions were satisfied, deferential business judgment review would apply.7

Initially it was unclear whether MFW could be applied at the pleadings stage, but subsequent Delaware

Supreme Court cases have confirmed that it can.8 MFW has become a powerful tool in deal structuring,

providing concrete incentives for controllers to disable themselves when negotiating with minority

stockholders (or disinterested special committees representing them) in return for gaining a reduced

likelihood of suit, and the potential early dismissal of any such action. Since MFW, Delaware courts have

repeatedly applied the MFW standard to deliver pleadings-stage dismissals.9

What Is Ab Initio and When Does It End?

Since MFW, courts and litigants have grappled with how early the controller must disable itself by insisting

upon the MFW protections. The Delaware Supreme Court made clear that the controller cannot use those

protections as a bargaining chip in the negotiations: from inception, the controlling stockholder must know

that it cannot bypass the special committee’s ability to say no and cannot “horse trade†by offering

minority protections later in the process in exchange for concessions.10

For example, in the first case to apply MFW at the pleadings stage, Swomley v. Schlecht, the Delaware

Court of Chancery noted that the controller’s initial proposal “hedged†on whether the majority-of-the-

minority condition would be waivable or not.11 However, the court nonetheless found the ab initio

requirement satisfied because the target’s board resolved, at its very first meeting after receiving the

offer, that any deal would require both a special committee’s approval and a majority-of-the-minority vote.

Thus, the court was satisfied that the MFW conditions were in place ab initio, noting “[a]ll this went down

before any negotiations took place, even before anything really started.â€12 The Delaware Supreme Court

affirmed without opinion.13

The court in Flood v. Synutra Int’l, Inc. subsequently elaborated upon the “before any negotiationsâ€

standard set out in Swomley.14 In Synutra, the initial letter of interest from the controlling stockholder did

not contain MFW’s dual protections.15 However, once a special committee had been formed, a second

letter of interest issued two weeks later preconditioned the deal on the MFW protections.16 The Delaware

Supreme Court noted that the special committee declined to engage in any price negotiations until the

committee’s banker could perform due diligence, and no price negotiations took place until seven months

after the MFW conditions were in place.17 Chief Justice Strine, writing for the majority, found that the

Latham & Watkins May 2, 2019 | Number 2493 | Page 3

controlling stockholder had successfully conditioned his offer “at the germination stage†and “self-

disable[d] before the start of substantive economic negotiations.â€18

In a dissent, however, Justice Valihura advocated for a more bright-line standard: controlling stockholders

must include the MFW conditions in the initial proposal itself.19 Justice Valihura opined that any doubt as

to whether the MFW protections were implemented in a timely fashion should be resolved against the

controller.20 She reasoned that a bright-line rule makes sense in the context of a controlling stockholder

take-private transaction, because the controller has the power to decide when to (i) begin negotiations,

and (ii) insist upon the MFW conditions.21 She posited that a bright-line rule serves the underlying purpose

of a speedy determination of the proper standard of review at the pleadings stage, while a vague

standard requiring the MFW protections to be in place before any negotiations occur invites a judicial

investigation into a “factual morass†that is inappropriate at the pleadings stage. 22

Olenik v. Lodzinski — Clarifying Timing Under MFW

This debate crystalized in the Delaware Supreme Court’s April 5, 2019 ruling in Lodzinski. In this case,

EnCap Investments L.P. (EnCap) owned 96% of one company, Bold Energy III LLC (Bold), and also a

majority stake in an entity that owned 41% of Earthstone Energy, Inc. (Earthstone).23 Earthstone, led by

its CEO and Chairman, Mr. Frank Lodzinski, was a mature-stage company operating in the upstream oil

and gas sector in Texas, but with limited undeveloped resources. Bold was an early-stage oil and gas

company with premium undeveloped acreage in Texas’s oil rich Midland Basin, but with limited resources

to drill and extract its holdings. In addition, EnCap, Bold’s financial sponsor, had reached the end of its

financial commitments in the summer of 2015 and was reluctant to invest more capital in the company.

The parties began discussing a combination transaction in the fall of 2015, and eventually consummated

a stock-for-stock deal in November 2016 that gave Earthstone stockholders 39% and Bold stockholders

61% of the equity of the combined entity.24 The combination offered a premium for Earthstone

stockholders based on the company’s trading price before the merger announcement, and Earthstone’s

stock jumped 27% on the day of the announcement. Ultimately, 99.7% of Earthstone’s minority

stockholders who voted on the transaction approved the deal. A group of dissenting stockholders brought

a class action suit in Delaware Chancery Court, claiming an unfair price. The Chancery Court dismissed

the case on the grounds that the MFW conditions had been satisfied and the transaction passed muster

under the business judgment standard of review.25 Plaintiffs appealed.

Plaintiffs alleged that, during the negotiations, Bold’s parent, EnCap, had sought to take Bold public or

sell the company or its assets, as early as June 2015, but a market check at the time came up empty.

Upon hearing of Bold’s unsuccessful efforts, Mr. Lodzinski initiated discussions with EnCap for an

acquisition of Bold’s assets in the fall of 2015. Between November 2015 and January 2016, Earthstone

engaged in an extensive review of Bold’s assets, and even sought valuation parameters from three

separate investment banking firms. By April 27, 2016, Mr. Lodzinski felt confident enough to send a letter

to the Earthstone Board of Directors stating that he was “updating [his] analysis†on Bold and that he

“intend[ed] to make an offer.â€26 This letter did not mention the MFW minority protections. The Supreme

Court’s unanimous opinion noted this omission, stating that “EnCap, Earthstone, and Bold were engaged

in substantive economic discussions … eight months before the MFW protections were put [in] place.â€27

In May 2016, without engaging an independent financial advisor, Earthstone made two presentations to

EnCap regarding a potential combination between Earthstone and Bold. Earthstone’s first presentation

valued Bold at US$305 million. When EnCap apparently did not respond to this presentation after a week,

Earthstone made a second presentation that valued Bold at US$355 million. Once again, neither

presentation mentioned the MFW minority protections. The Court identified these valuations as the

discernible dividing line at which discussions transitioned from “preliminary discussions ... to substantive

Latham & Watkins May 2, 2019 | Number 2493 | Page 4

economic negotiations when the parties engaged in a joint exercise to value Earthstone and Bold.â€28 The

valuations were particularly probative because “[b]ased on these facts, it is reasonable to infer that these

valuations set the field of play for the economic negotiations to come by fixing the range in which offers

and counteroffers might be made.â€29

On July 8, 2016 — more than two months after Mr. Lodzinski’s initial letter to the Earthstone Board, and

more than eight months after his initial discussions with EnCap — Earthstone’s two independent directors

began taking steps to form a special committee to oversee the transaction. Earthstone’s Board did not

actually form the special committee until July 29, 2016. When Earthstone made its first formal proposal to

Bold on August 19, 2016, the proposal conditioned the transaction on the MFW protections for the first

time. The offer was for an all-stock transaction valuing Bold at US$325 million — well within the range set

out in the May valuations.

The Appellees contended that they satisfied MFW because the first binding offer was conditioned on the

MFW protections, and they discounted the prior discussions as merely exploratory discussions that did

not rise to the level of the substantive economic negotiations standard enunciated in earlier Delaware

case law. The Delaware Supreme Court disagreed, given the advanced nature of the economic

discussions that occurred. The Court instead concluded that the Appellant “ha[d] pled facts that

support[ed] a reasonable inference that the two procedural protections were not put in place early and

before substantive economic negotiation took place.â€30 The Chancery Court’s dismissal on MFW grounds

was overturned.

Best Practices for Controllers Engaging in Take-Private Transactions

If a controlling stockholder engages in a take-private merger (or other transaction over which the

stockholder can exert substantial influence), and wants to have the transaction reviewed under the

deferential business judgment standard rather than the much more stringent entire fairness standard, the

controller should condition the transaction on the MFW protections from the very first discussion or initial

offer. As Justice Valihura observed, the controller has total authority over when the merger discussions

commence and is uniquely empowered to condition any negotiations on these protections. If pre-

negotiation disablement is, for whatever reason, not feasible, Lodzinski requires a controller to insist on

the MFW protections before the controller commences substantive negotiations in order to obtain the

benefit of the business judgment standard.

Lodzinski, like Synutra before it, seems to indicate that, to obtain the benefit of the business judgment

standard, a controller only need insist that the transaction be subject to the MFW protections, not that the

protections actually be in place before the start of negotiations. However, the logical interpretation of

these decisions is that a controller wishing to have the benefit of the protections cannot commence

substantive negotiations until the party charged with protecting minority stockholders’ interests (usually a

committee of the target company’s board composed of disinterested directors) have agreed to and

implemented the protections. Courts look at substance rather than form in determining what constitutes

substantive discussions. Thus, even if a controller does not make a binding, written offer that the other

party can accept, if the controller engages in exploratory talks about economic value, terms, or the

structure of a transaction that arguably have the effect of narrowing the negotiating range, the controller

runs the risk that the court will find that MFW protections should have been in place before those

discussions began. Lodzinski indicates that valuation discussions can be tantamount to substantive

economic negotiations, particularly if they set the parameters for subsequent economic negotiations.

Controlling shareholders cannot circumvent the procedural safeguards of MFW by nominally offering the

MFW conditions after negotiations are well under way, or after the economic goalposts have effectively

been narrowed.

Latham & Watkins May 2, 2019 | Number 2493 | Page 5

If you have questions about this Client Alert, please contact one of the authors listed below or the Latham

lawyer with whom you normally consult:

Thomas W. Christopher [email protected] +1.212.906.1242 New York

Blair Connelly [email protected] +1.212.906.1200 New York

Blake T. Denton [email protected] +1.212.906.1239 New York

Sohom Datta [email protected] +1.212.906.4724 New York

You Might Also Be Interested In

Business Judgment Rule Applies to Merger Approved by Informed, Disinterested Stockholders

Entire Fairness in Controlling Stockholder Transaction: In re Orchard Enterprises, Inc. Stockholder

Litigation

Client Alert is published by Latham & Watkins as a news reporting service to clients and other friends.

The information contained in this publication should not be construed as legal advice. Should further

analysis or explanation of the subject matter be required, please contact the lawyer with whom you

normally consult. The invitation to contact is not a solicitation for legal work under the laws of any

jurisdiction in which Latham lawyers are not authorized to practice. A complete list of Latham’s Client

Alerts can be found at www.lw.com. If you wish to update your contact details or customize the

information you receive from Latham & Watkins, visit https://www.sites.lwcommunicate.com/5/178/forms-

english/subscribe.asp to subscribe to the firm’s global client mailings program.

Endnotes

1 88 A.3d 635 (Del. 2014).

2 Kahn v. Lynch Commc’n Sys., 638 A.2d 1110, 1117 (Del. 1994) (“[T]he exclusive standard of judicial review in examining the

propriety of an interested cash-out merger transaction by a controlling or dominating shareholder is entire fairness.â€).

3 No. 392, 2018, 2019 WL 1497167 (Del. Apr. 5, 2019).

4 Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1983); Kahn v. Lynch Commc’n Sys., 638 A.2d 1110 (Del. 1994). Kahn v. Lynch

established that steps to protect minority interests could, at best, result in burden shifting at trial.

Latham & Watkins May 2, 2019 | Number 2493 | Page 6

5 The Court listed requirements to ensure that the special committee was properly empowered, such as being able to hire its own

advisors, negotiate with the controller, and definitively reject any offer from the controller and end the negotiations. MFW, 88

A.3d at 645.

6 88 A.3d at 645.

7 Id. at 644-45.

8 See, e.g., Daniel Gold and Scott Ewing, New Guidance on How MFW Operates at Pleading Stage, LAW360 (Sept. 10, 2014, 10:55

AM), https://www.law360.com/articles/575685/new-guidance-on-how-mfw-operates-at-pleading-stage.

9 See, e.g., In re Books-A-Million, Inc. S’holders Litig., C.A. No. 11343-VCL, 2016 WL 5874974 (Del. Ch. Oct. 10, 2016), aff’d, 164

A.3d 56 (Del. 2017) (Table); Swomley v. Schlecht, C.A. No. 9355-VCL (Aug. 27, 2014) (Transcript Ruling), aff’d, 128 A.3d 992

(Del. 2015) (Table).

10 In re MFW S’holders Litig., 67 A.3d 496, 528 (Del. Ch. 2013); Flood v. Synutra Int'l, Inc., 195 A.3d 754, 756 (Del. 2018).

11 C.A. No. 9355-VCL (Aug. 27, 2014) (Transcript Ruling), aff’d, 128 A.3d 992 (Del. 2015).

12 Id.

13 Id. Similarly, in In re Books-A-Million, Inc. S’holders Litig., the controller conditioned any transaction on the MFW dual protections

in the initial proposal, leading the court to commend that the controller did not “delay[] establishing the conditions, waver[] from

them, or … [seek] to circumvent them.†2016 WL 5874974, at *8.

14 195 A.3d 754 (majority opinion).

15 Id. at 757.

16 Id. at 758.

17 Id.

18 Id. at 763.

19 Id. at 768 (Valihura, J., dissenting)

20 Id. at 779-80.

21 Id.

22 Id. at 776, 779-80.

23 Appellees argued that EnCap’s 41% stake did not qualify it as a controlling stockholder, but the Delaware Supreme Court rejected

this argument due to facts pleaded in the complaint that supported the Appellants’ control theory. Lodzinski, 2019 WL 1497167,

at *10.

24 The deal structure in the Earthstone/Bold transaction was not a classic take-private by a controlling stockholder. The two principal

parties to the business combination (Earthstone and Bold) were directly or indirectly controlled by the same parent entity

(EnCap), and the MFW issue arose in the context of the fairness of the transaction to Earthstone’s minority stockholders. The

Court noted that “[a]lthough the Earthstone/Bold transaction is not a transaction between the controlling stockholder and a

controlled company, the same principles apply whether the controller is directly or indirectly exerting its influence over the

transaction.†Lodzinski, 2019 WL 1497167, at *7 n.50.

25 Olenik v. Lodzinski, No. CV 2017-0414-JRS, 2018 WL 3493092 (Del. Ch. July 20, 2018).

26 Lodzinski, 2019 WL 1497167, at *3.

27 Id. at *10.

28 Id. at *9.

29 Id. The Court noted that this is what essentially transpired under the facts as alleged.

30 Id. at *10.

This article is made available by Latham & Watkins for educational purposes only as well as to give you general information and a general understanding of the law, not to provide specific legal advice. Your receipt of this communication alone creates no attorney client relationship between you and Latham & Watkins. Any content of this article should not be used as a substitute for competent legal advice from a licensed professional attorney in your jurisdiction.

Latham & Watkins LLP - Thomas W. Christopher, Blair Connelly, Blake T. Denton and Sohom Datta

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