Delaware Court Dismisses Action Against Seller’s Directors and Financial Advisor

On October 24, 2014, the Delaware Court of Chancery issued a decision, In Re: Crimson Exploration Inc. Stockholder Litigation, addressing when: (i) a stockholder with less than majority voting power may be deemed a controlling stockholder, and (ii) the controlling stockholder’s actions trigger “entire fairness” review of a challenged merger. The court also rejected criticisms of the seller’s financial advisor based on supposed conflicts of interest and flawed valuation methodologies.

The decision provides important guidance for directors and their advisors in merger transactions where one stockholder or a cohesive group of stockholders holds a sizable share of company stock.

Background

The case involved a post-closing challenge to Contango Oil & Gas’ acquisition of Crimson Exploration in a stock-for-stock merger at a price representing a 7.7% premium to Crimson’s share price on the date the merger agreement was signed. At the time, Oaktree Capital Management and certain affiliates owned 33.7% of Crimson’s common stock and Oaktree was a lender under Crimson’s $175 million facility. Oaktree, together with Crimson management, executed support agreements resulting in 37.25% of Crimson’s common shares being locked-up in favor of the merger. Upon closing, Crimson stockholders owned approximately 20%, and Oaktree owned approximately 7%, of the merged company.

Importantly, Oaktree entered into two “side deals” with Contango that were not part of the merger agreement and were “anticipated” but not formally agreed to until after the agreement was signed: (i) a Registration Rights Agreement that would permit Oaktree more easily to sell its stock in the combined entity; and (ii) an agreement by Contango to pay off early the $175 million lending facility, including a 1% prepayment penalty.

The plaintiffs contended that Oaktree used its control of Crimson to advance its own interests, which resulted in the approval of a transaction that undervalued Crimson. The court found that the transaction should be reviewed under the business judgment rule and granted defendants’ motion to dismiss. In its decision, the court provided important guidance concerning when the existence of a large stockholder who negotiates certain “side deals” will cause the transaction to be reviewed under the strict entire fairness standard.

Takeaways

The court stated that entire fairness review is appropriate only where a controlling stockholder is involved in a transaction and its interest conflicts with the interests of minority stockholders. The court addressed, but ultimately did not decide, whether Oaktree was a controller because it found no conflict between Oaktree and other common stockholders.

Control

Although not deciding the issue, the tone of the court’s opinion evidences skepticism toward plaintiffs’ claims of control of Crimson by Oaktree. The court rejected the allegation that Oaktree controlled more than 50% of the stock because its interests were aligned with a 15% stockholder. “[M]ere concurrence of self-interest” among stockholders is insufficient to deem them a “control group.” Instead, plaintiffs need to plead that they are “connected in some legally significant way,” i.e., by contract or “other arrangement,” and the complaint here did not contain that allegation.

The court also found, following a “fact-intensive” analysis, insufficient allegations that Oaktree “actually exercised control” over the business affairs of Crimson. While not outright rejecting plaintiffs’ contentions at the motion to dismiss stage, the court cast doubt that plaintiffs could plead control based on the facts that three of seven members of the Crimson board worked for Oaktree or that a fourth director, Crimson’s CEO, allegedly was loyal to Oaktree and consulted with Oaktree before bringing the potential merger to the board’s attention. An inference of control based on these allegations was “questionable” given that Oaktree “would suffer the most from a low merger price, given its holdings of over 15.5 million shares,” and that the CEO was not employed by Oaktree. In sum, plaintiffs did not present “a reasonably coherent theory as to why the key players would undersell their millions of shares” in Crimson.

The court’s discussion of control is notable for its thorough consideration of the variety of circumstances under which a less than 50% shareholder may be deemed a controller. The court emphasized that for entire fairness to apply, plaintiffs must show that a large stockholder actually exercises control over the board’s decisions about the challenged transaction. The court firmly rejected any numerical ownership test (other than majority ownership) for determining control. The decision also reaffirms that mere allegations of a close working relationship between management and a large stockholder do not plead control.

Conflicted Transaction

The court stated that a controlling stockholder is conflicted with respect to a transaction, such that entire fairness review is appropriate, where: (a) the controlling stockholder is on both sides of the deal; or (b) the controlling stockholder competes with the other stockholders for consideration because: (1) the controller received disparate consideration, which the board approves, (2) the controller retains a continuing stake in the surviving entity, whereas the minority is cashed out, or (3) the controller receives a unique benefit, despite nominal equal treatment of all stockholders.

The court observed that the first three scenarios were not applicable. Oaktree was not on both sides of the deal since it had no interest in Contango and Oaktree received the same merger consideration as all other stockholders, so it did not receive disparate consideration nor was the minority excluded from a continuing stake in the combined company.

The court then rejected plaintiffs’ assertion that the early loan prepayment with a 1% penalty constituted a unique benefit. Because Contango did not agree to prepay the loan until after the parties signed the merger agreement, such prepayment “could not qualify as additional or different merger consideration.” Additionally, the court doubted “that the 1% prepayment fee would compensate Oaktree sufficiently to cause it to take a lower price for its shares,” especially given that there were “no allegations questioning Crimson’s ability to repay the debt.” In short, these allegations could not overcome the fact that “stockholders generally are presumed to have an incentive to seek the highest price for their shares.”

The court likewise was not persuaded that the Registration Rights Agreement, “standing alone, conceivably could be a sufficient benefit to require application of the entire fairness standard here.” The Registration Rights Agreement was of “minimal cash value” to Oaktree and no cash value to the minority stockholders, who would be able to sell freely in the public markets. Although the Registration Rights Agreement enhanced Oaktree’s liquidity, the underlying transaction largely achieved that result by reducing Oaktree’s stake in the combined entity to approximately 7%. For liquidity needs to be deemed a conflict, the court held, there would have to be circumstances, not pled here, involving “a crisis, fire sale” of the company.

The decision confirms that, even at the pleading stage, large stockholders have a powerful argument against allegations of self-interested conduct in the merger context. To overcome the presumption that stockholders are incentivized to seek the highest price for their shares, plaintiffs must allege “specific facts or theories persuasive enough to render it reasonable” to conclude that the supposed controller acted contrary to its “self-interested incentives as stockholders to maximize value.” The court also attached substantial weight to the fact that the loan prepayment and Registration Rights Agreements were not part of the merger agreement or approved by the board, even though they were “anticipated” at the time the agreement was signed. This suggests that it may be advantageous for a large stockholder to defer agreements on “side benefits” until after the board has approved a transaction, although doing so also carries associated risk of not reaching an agreement.

Business Judgment Rule

The court then concluded that the complaint failed to plead facts sufficient to overcome the business judgment rule presumption that the directors approved the transaction in good faith and on an informed basis. In so concluding, the court rejected criticism leveled at Crimson’s financial advisor, Barclays. Plaintiffs asserted that Barclays was conflicted due to its relationship with Oaktree because a Barclays affiliate acted as the lending agent on the $175 million loan facility and Barclays advised Oaktree on two significant divestitures. The court found that because Oaktree was not conflicted, i.e., Oaktree did not have an objective materially different than other company stockholders, Barclays likewise was not conflicted. The court also held that allegations that Contango’s financial advisor placed a higher value on Crimson than Barclays and that Barclays chose unreasonably high discount rates were insufficient to plead bad faith.

Recently, the Delaware Chancery Court has issued several decisions critical of the conduct of sellers’ financial advisors. See, e.g., In Re Rural/Metro Corporation Stockholders Litigation, C.A. 6350-VCL (October 10, 2014); Chen v. Howard-Anderson, C.A. 5878-VCL (April 8, 2014); In re Orchard Enterprises, Inc. Stockholder Litigation, C.A. 7840-VCL (February 28, 2014). The Crimson decision provides perspective on these decisions in summarily rejecting plaintiffs’ criticisms.

For a copy of the decision, please click here.