In Crimson Exploration Inc. Stockholder Litigation (Oct. 24, 2014), the Delaware Chancery Court continues the trends we have described in recent memoranda to clients—i.e., the court’s increasing inclination to apply business judgment review of mergers, to apply a narrow definition of “control” for non- majority shareholders, and to dismiss board fiduciary duty cases at the pleading stage, unless there is a self-dealing transaction or blatantly flawed process. Crimson is in line with other recent decisions of the court – including Ancestry.com (in which this firm acted for acquiror Permira), as well as, most recently, Morton’s Restaurant – that provide greater certainty in connection with sales of companies by private equity firms that have taken companies public while retaining a significant equity interest.
The underlying premise of the court’s approach in Crimson is that, even when there is a controller, if the controller’s interests are aligned with the interests of the public shareholders, there is no conflict giving rise to entire fairness review unless the shareholder is a counter-party to the transaction or receives special treatment that undoes the alignment of interests. In Crimson, the plaintiff-shareholders had argued that the Crimson board had been controlled by Crimson’s 33.7% shareholder, Oaktree Capital Management, and that Oaktree had supported a stock merger with Contango Oil & Gas because it wanted liquidity and also received special benefits in the merger, and therefore was willing to sell its shares at less than full value in the merger. Vice Chancellor Parsons suggested that plausible facts were not alleged that gave rise to a reasonable inference that Oaktree had exercised actual control over the board’s decision on the merger. He emphasized, moreover, that business judgment review would apply whether or not the shareholder had been a controller.
- Business judgment: Business judgment review will apply to a stock merger when a major shareholder of the target – even if a controller – has no conflict with respect to the merger.
- Controller conflict: A major shareholder – even if a controller – will not have a conflict unless it is a party to the transaction or receives special treatment that is “valuable” enough to rebut the presumption of an alignment of interests with the other shareholders in maximizing the merger price.
- Control: A non-majority shareholder – even though owning almost 34% of the outstanding shares, designating a majority of the board, and 3 of the 7 directors being its employees –
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is not a controller unless it exercises actual control over the company’s board with respect to the transaction at issue.
- Director independence: If a controller is not conflicted with respect to a transaction, company directors will not be considered to lack independence solely based on their affiliation with the controller.
The Court’s Analysis
- Presumption that all shareholders want to maximize the value of their shares. The court reaffirmed the principle that there is a presumption that all shareholders, including controllers, have the same interest in maximizing the merger price in a merger with a third party – even in an equity transaction where the price maximization principle of Revlon does not apply. Unless there is evidence that a controller has a materially different interest, the controller has no conflict and business judgment review will apply.
n If a controller receives different treatment in a merger, the presumption may be rebutted, but only if the different treatment resulted in value received by the controller that was greater than the value a higher merger price would have represented.
- Controller desire for liquidity. A major shareholder’s desire to exit an investment (i.e., for liquidity) is not a different objective from that of the other shareholders , the court said, unless the controller has a “compelling” or “idiosyncratic” liquidity problem that leads to a reasonable inference that it would sell its shares for less than full value. In Crimson, plaintiffs’ pleading that Oaktree had held its Crimson investment for 8 years, instead of the 5-year timeframe that had been typical for Oaktree’s investments, did not demonstrate a compelling liquidity problem, the court said.
- Controller receiving disparate consideration or special benefits. A controller receiving special treatment in a merger – i.e., disparate consideration or a unique benefit – may create a conflict that would invoke entire fairness review.
- Repayment of debt. In Crimson, the court did not view a repayment of debt by Crimson to Oaktree as constituting disparate merger consideration to Oaktree. The court noted that the repayment had not been demanded by Oaktree and that there had been no agreement for repayment; rather, the repayment had been “anticipated” by the parties as an apparent detail of the mechanics of the merger. Moreover, the repayment paled as a benefit to Oaktree as compared to the benefit a higher merger price would have represented – especially because there was no allegation that Crimson had been in financial distress.
- Obtaining registration rights. The court also did not view the company’s providing Oaktree with a registration rights agreement (RRA) as a unique benefit that was sufficient to create a conflict. As Oaktree had demanded that it receive registration rights and the RRA was negotiated at the same time as the merger agreement, the court viewed the RRA as “more integral” to the merger agreement than the repayment of debt (described above). However, the court stated that the RRA had “little cash value” to Oaktree (“just attorney’s fees and costs”) and would have had no
value to the other shareholders if given to them because they could easily sell their shares in the market without registration.
- Actual control of the board is evidenced by “literal domination”. Although irrelevant to the court’s conclusion, the court indicated that “actual control” is evidenced by a shareholder “literally dominat[ing] the boardroom,” making specific threats as to actions it would take if its demands were not met, or expressing to the board that the board has to do what the shareholder demands. In Crimson, Oaktree owned 33.7% of the company’s shares, was a major creditor of the company, had designated a majority of the board and of senior management, had employed 3 of the 7 directors while they were serving as directors, and had a longstanding relationship with the CEO. While the Vice Chancellor declined to make definitive findings on the pleadings, he indicated his view that Oaktree likely had not exercised actual control over the board’s decisions relating to the merger, noting that: Oaktree was “an outside investment fund”; the lead negotiators for the merger (the CEO and the CFO of Crimson) “were not employed by Oaktree”; and Oaktree did not instigate the merger or even know about Contango’s interest until the Crimson CEO had begun negotiations with Contango and then informed Oaktree.
n An actual conflict is required to rebut the presumption of a director’s independence.
- Directors may be independent even if they are affiliated with a controller. If a controller is not conflicted with respect to a transaction, the directors affiliated with it will not be considered to lack independence due to the affiliation. In Crimson, although several of Crimson’s directors had been employees of Oaktree while they served as Crimson directors (and a majority of the board had been designated by Oaktree), the court did not consider these directors to have lacked independence or disinterestedness in the merger, as Oaktree had the same interest in maximizing the value of Crimson’s shares in the merger as the other shareholders had.
- Directors may be independent even if they negotiated post-transaction employment— unless the value to the director from the arrangement offsets the loss to the director from obtaining a lower-than-necessary merger price on his shares. Only the Crimson CEO, who was also a director, was viewed by the court as possibly having lacked independence because he may have negotiated for post-transaction employment with the surviving corporation while the merger was being considered. However, the court noted, the presumption of his independence would be rebutted only if the personal gains he achieved through the employment arrangement had been valuable enough to offset the loss to him from accepting a lower-than-necessary merger price for his shares. The court noted that his
$150,000 salary increase was “dwarfed by” the amount he received for his 1 million shares and the $1.8 million he received as a result of accelerated vesting of his restricted stock.
- Directors may be independent even if they continue as directors of the surviving corporation. The court reaffirmed that a director continuing as a director of the surviving corporation does not itself render the director as having been interested or non-independent with respect to the merger.
- Entire fairness may be invoked based on lack of board independence only if a majority of the board lacks independence. Lack of disinterestedness or independence of directors may invoke entire fairness review only if these defects apply to a majority of the board. Thus,
in Crimson, the court said that lack of independence of the directors would have invoked entire fairness review only if the benefit to the CEO-director from his post-transaction employment would “have been so powerful that it overtook the value he derived from is own shares and led him to dominate [a number of directors that constituted a majority of the board].” (emphasis in original)
- Bad faith is established only by an “extreme” set of facts. Bad faith is a breach of the duty of loyalty and a bar to exculpation under DGCL § 102(b)(2). The Vice Chancellor reiterated the court’s general view that there is a high pleading standard for bad faith, requiring an “extreme set of facts”. Crimson confirms that an extreme set of facts establishing bad faith is likely to be rare, even where there is a controller, if the controller’s interest is aligned with the other shareholders’ interest in maximizing the merger price.
- Low premium. A merger price representing a low premium does not itself indicate bad faith by a board, unless it “so exceeds the bounds of reason” that it is explainable only by bad faith, the court said. The premium in Crimson was 7.7%. Plaintiffs pled that management had consistently provided investors with per share valuations in a range the upper end of which exceeded the merger price by more than ten-fold. The court noted that plaintiffs had not alleged that a higher price reasonably was available, whether from Contango or another buyer; that the price was the product of over four months of negotiations (during which time no other buyer emerged); and that the company’s bankers opined that the price was fair.
- Investment bank’s pre-existing relationship with controller. Plaintiffs argued that the board exhibited bad faith by relying on a fairness opinion that was “suspicious” because the banker was “beholden” to the company’s putative controller based on their pre-existing relationship. A pre-existing relationship of the company’s banker with a controller of the company will not create a conflict of interest that impugns the bank’s fairness opinion unless the controller itself has a goal other than achieving the highest value for its shares, the court said. The banker had acted as lending agent on the company’s credit facility under which Oaktree was a creditor and had been hired by Oaktree to advise it on two significant divestiture deals. For the relationship to constitute a conflict, the court said, Oaktree “would need to have an objective materially different from Crimson and [Crimson]’s other stockholders, i.e., a goal other than achieving the highest value for its shares.”
- Reliance on flawed fairness opinion. The court viewed plaintiffs’ allegations of flaws in the banker’s fairness opinion as not establishing bad faith but, rather, “amount[ing] to little more than disagreements with [the banker’s] methods or a belief that another financial advisor would have done a better job.” The plaintiff did not allege flaws that were “so serious that they would negate the Crimson directors’ ability to rely, in good faith, on [the banker’s] professional advice,” the court said. Plaintiffs’ main complaints were that the banker had consistently valued Crimson lower than Contango’s banker had; had used an unreasonably high discount rate; and had not considered certain valuable assets (which assets, the court found, related to an oil well that had not become relevant until after the merger).
- Totality of the circumstances continues to matter. While not central to the court’s stated rationale for its major findings, the court noted a number of factors that underscore that the totality of the circumstances continues to matter, notwithstanding the court’s continued general inclination to apply business judgment review. Specifically, the Crimson board had explored at
least six strategic alternatives before any negotiations with Contango began; the board had hired independent advisors, including an investment bank, legal counsel, and engineering consultants; and the board had met numerous times formally and informally to discuss the merger.
The court concluded that Oaktree probably was not a controller of Crimson – even though Oaktree owned almost 34%, was a major creditor, had designated a majority of the board and of senior management, and had 3 of its employees serving as directors (on a 7-person board) – because it had not exercised actual control over the board’s decision on the merger. The court emphasized, moreover, that business judgment review would apply whether or not Oaktree had been a controller, as Oaktree was not conflicted in the transaction but, rather, had the same interest the other shareholders did in the merger price being as high as possible.