Delaware Court Preliminarily Enjoins Merger Due to Flawed Sales Process

The following post comes to us from Jason M. Halper, partner in the Securities Litigation & Regulatory Enforcement Practice Group at Orrick, Herrington & Sutcliffe LLP, and is based on an Orrick publication by Mr. Halper, Peter J. Rooney, Christin Joy Hill, and Christine M. Smith. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

On November 24, 2014, the Delaware Court of Chancery preliminarily enjoined for thirty days a vote by C&J Energy Services stockholders on a merger with Nabors Red Lion Limited, to allow time for C&J’s board of directors to explore alternative transactions. In a bench ruling in the case, City of Miami General Employees’ & Sanitation Employees’ Retirement Trust v. C&J Energy Services, Inc., Vice Chancellor Noble concluded that “it is not so clear that the [C&J] board approached this transaction as a sale,” with the attendant “engagement that one would expect from a board in the sales process.” Interestingly, the Court called the issue a “very close call,” and indicated it would certify the question to the Delaware Supreme Court at the request of either of the parties (at this time it does not appear either party has made a request). The decision provides guidance regarding appropriate board decision-making in merger transactions, particularly where one merger party is assuming minority status in the combined entity yet also acquiring management and board control.

Background

C&J and Nabors operate in the oilfield completion and production services business. The idea for a merger arose after Citibank bankers approached the CEOs of both companies to suggest a transaction. The C&J-Nabors merger agreement, which was announced in June 2014, provided for the formation of a new company in Bermuda (“New C&J”), which would issue stock to the stockholders of both companies and also pay cash consideration to Nabors stockholders.

Pursuant to the merger agreement, each share of C&J common stock would be converted into the right to receive one share of New C&J stock and all the shares of Nabors would be converted into the right to receive aggregate consideration of approximately 62.5 million shares of New C&J stock and approximately $940 million in cash. Following the closing of the transaction, former Nabors stockholders would own approximately 53% of the outstanding New C&J shares, with existing C&J stockholders owning approximately 47% of the combined company. In addition, C&J’s management would lead the merged company.

The agreement also provided that four members of C&J’s board would be appointed to and comprise the majority of the new entity’s board with guaranteed five-year terms, although the identity of the non-management directors who would join the merged company’s board was not decided upon at the time the agreement was signed. The Court also found that C&J’s post-merger minority status was driven by tax considerations, with the transaction structured as an inversion and the combined company registered in Bermuda.

On November 24, the Court granted a 30-day preliminary injunction to permit the C&J board to explore alternatives to the Nabors transaction. The Court did so primarily because in “approving the transaction, the board did not consider alternative transactions. The board did not seek out other potential buyers. The board’s review of the merger process was more akin to what one would expect from a board pursuing an acquisition rather than one selling a company.”

Takeaways

  • Directors Have Obligations When Selling Stockholder Control Regardless of Management or Board Control of the Combined Entity. The Court found, in effect, that selling control triggers a certain level of board engagement regardless of other considerations. The Court observed that the C&J’s shareholders’ minority status may have been driven by potential tax savings associated with an inversion, C&J internally viewed the transaction as an acquisition and not a sale, and C&J would retain management and board control post-closing. Ultimately, however, C&J shareholders were exchanging 100% ownership of C&J for 47% control in the post-merger entity. None of the other considerations noted above changed the fact that C&J shareholders “technically no longer will have collective control.” Likewise, the fact that C&J shareholders are adequately informed and can vote on the deal did not suffice because, according to the Court, they are “entitled to have a sales process run when their company is being sold.”
  • Directors Have A Particularly Compelling Obligation To Understand A Merger Partner’s Business And Financial Condition in a Single-Buyer Stock Transaction. The Court made clear that it was “not suggesting any specific steps that the board needed to take.” Nonetheless, C&J did not engage in any market check prior to agreeing to merge with Nabors, and the Court found it “imperative” in that situation that the “board have impeccable knowledge of the value of the company that it is selling.” Here, even though C&J’s management apparently believed they could substantially improve Nabor’s performance, that was not a substitute for understanding the value of Nabors’ business and assets, which in turn will form a substantial part of the value of the combined company in which C&J shareholders are acquiring a 47% interest. This consideration was particularly significant here, where over the course of negotiations C&J agreed to increase the deal value to Nabors shareholders from $2.6 billion to $2.9 billion even as Nabors was revising its own financial projections downward, Deloitte was forecasting a “continued downward trend in profitability” following its due diligence assessment, and C&J’s CEO questioned the credibility of Nabors’ accounting. The Court contrasted the situation in a cash transaction, where “the value of the acquiring company, assuming it can pay the merger price, is not that critical.”
  • Active Involvement in Negotiations and/or Approval by a Board or Board Committee That Unquestionably Is Independent and Disinterested Can Affect the Outcome Even Where The Board Does Not Have A Legally Disqualifying Interest. The Court observed that C&J’s Board delegated primary responsibility for negotiating the transaction to the Company’s CEO, who is to lead the combined entity. And, the Board did not form a special committee to address the transaction even though four directors, comprising a majority of the C&J Board, were guaranteed membership on the combined entity’s board for terms of five years. While neither of these considerations was determinative, the Court found that the “five-year guarantee is a unique status and it raises concern,” even if it did not render the board interested in the transaction. Still, the Court found that the five-year guarantees of post-closing board membership remained a “factor” at the preliminary injunction stage. The Court’s ruling highlights the importance of approval of a challenged transaction by a board whose disinterest and independence is beyond question. Consideration should be given to whether or to what extent it is necessary to provide in the merger agreement for long-term guarantees of post-closing benefits to the seller’s board or management. In this way, the decision is consistent with Vice Chancellor Parson’s recent opinion in In Re: Crimson Exploration Inc. Stockholder Litigation. There, albeit in a quite different context, the Court found that certain side benefits granted to a large stockholder of the seller in a merger transaction did not create a conflict with other shareholders warranting entire fairness review. The side benefits were: (i) a registration rights agreement that would permit the stockholder more easily to sell its stock in the combined entity; and (ii) an agreement by the acquirer to pay off early a loan by the large stockholder, including a 1% prepayment penalty. In so holding, the Court attached substantial weight to the fact that these benefits were not part of the merger agreement or approved by the board, even though they were “anticipated” at the time the agreement was signed.
  • Other Considerations Can Mitigate The Scope Of Injunctive Relief Even Upon A Finding of a Likely Due Care Breach. The Court observed that in the five months following announcement of the transaction, no other bidders emerged even though the universe of potential bidders was small and “it is impossible to believe that they do not know about the transaction.” That fact, combined with the “relatively modest” deal protection measures in the merger agreement, made it “easy to be skeptical” that another buyer would emerge or that the deal was “as bad” as plaintiff contended. Although not expressly stated in the bench ruling, the absence of other potential bidders emerging over a five-month period appears, at least in part, to have led the Court to make a “relatively modest” adjustment to the deal by enjoining the stockholder vote for 30 days, during which time the C&J board “shall solicit interest.” The injunction is to expire at the end of that period if no other transaction develops.
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