Delaware Supreme Court Holds That Revlon Does Not Require Active Market Check

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 December 19, 2014, the Supreme Court of Delaware reversed the Delaware Court of Chancery’s November decision (discussed on the Forum here) to preliminarily enjoin for 30 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. The Supreme Court decision clarifies that in a sale-of-control situation, Revlon and its progeny require an effective, but not necessarily active, market check, and there is no “specific route that a board must follow” in fulfilling fiduciary duties.

The decision also reaffirms the type of record that must be made to support a mandatory preliminary injunction, a type of injunction that requires parties to take affirmative actions as opposed to merely maintaining the status quo. The Court found that the Chancery Court “blue penciled” the merger agreement, and in the process stripped Nabors of its contractual rights, by effectively inserting a go-shop provision into the contract where the parties never agreed to one. Moreover, the Chancery Court improperly did so without finding that Nabors aided and abetted a fiduciary duty breach and based its holding only on disputed facts that were not adjudicated following a trial. While the decision does not break new ground, it is significant in better defining directors’ duties when selling control and articulating the limits of a court’s ability to issue mandatory preliminary injunctions.

Background

C&J and Nabors operate in the oil field completion and services business. 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. 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. 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 yet decided at the time the agreement was signed. 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 Chancery Court granted a 30-day preliminary injunction during which the C&J board was ordered to explore alternatives to the Nabors transaction. The Court’s rationale primarily was that the C&J board did not affirmatively seek out other potential merger partners either before or after signing the merger agreement.

Takeaways

  • Revlon requires an “effective,” but not necessarily “active,” market check. While Revlon holds that in a change-of-control transaction, a board “must not take actions inconsistent with achieving the highest immediate value reasonably attainable,” Revlon does not require a board to “set aside its own view of what is best for the corporation’s stockholders and run an auction.” Rather, in assessing whether a board satisfied its obligation to make “a reasonable decision, not a perfect decision,” the transaction should be subject to an “effective market check,” meaning that there is an opportunity to receive higher bids and the board has “flexibility” to accept any such offers. Active solicitation of higher bids is not necessarily required. For context, the Court also offered a reminder of the “too often forgotten” fact that unlike here, Revlon, QVC and their progeny involved “board resistance to a competing bid” to a pending merger agreement that threatened to “impede the emergence” of a higher-priced deal.
    Here, according to the Supreme Court, the lower court could not have found that plaintiffs were likely to succeed on the merits of their claims when it incorrectly applied Revlon and in light of facts suggesting an appropriate sales process and effective market check: (i) the merger agreement provided the C&J board with a “fiduciary out,” allowing it to (a) negotiate with third parties under certain circumstances, and (b) terminate the deal in favor of a superior proposal for a “modest” $65 million termination fee (2.2% of the deal), but in the five months following the signing of the merger agreement no other bidders emerged; (ii) the C&J board had no improper motive and was well-informed about C&J’s value; and (iii) stockholders were adequately informed and had the opportunity to vote on the deal.
  • “Blue penciling” a contract in the form of a mandatory injunction is an extraordinary remedy that requires an appropriate procedural and factual basis. The lower court’s ruling preliminarily enjoined C&J’s shareholder vote for thirty days, during which C&J was ordered to actively shop itself. Even though the C&J and Nabors merger agreement did not provide for such a go-shop period, the lower court found that requiring C&J to solicit superior bids would not constitute a breach of the contract. The Supreme Court held that the lower court should not have issued such an injunction based on disputed facts that were not adjudicated following a trial. As importantly, the Supreme Court observed that the court’s equitable authority is not “uncabined” and cautioned about issuing such injunctions, at least in the circumstances here: the record did not support forcing “Nabors to endure a judicially-ordered infringement of its contractual rights that would, by judicial fiat, not even count as a breach of Nabors’ rights.” This conclusion was especially warranted given the absence of any finding that Nabors acted wrongfully and the fact that stockholders are “capable of addressing that [alleged] harm themselves” by voting against the transaction.
    The decision reinforces the respect Delaware courts will accord to contractual rights and obligations negotiated and agreed to by an informed and independent board and the courts’ reluctance to “take the decision out of” stockholders’ hands when they have an opportunity to vote on a transaction on an informed basis.
  • Sufficient protections for selling stockholders in a merger agreement may make Revlon inapplicable. The Supreme Court stated that the merger agreement contained certain provisions intended to “ensure” that C&J stockholders “would retain some control over New C&J.” In addition to providing that C&J directors would comprise a majority of the New C&J board and hold office for five-year terms and that C&J’s CEO would lead the post-closing entity, the merger agreement provided that: (i) New C&J would have a bylaw requiring that all stockholders receive pro rata consideration in any sale of the company or major assets, and the by-law could not be repealed without unanimous stockholder approval; (ii) a vote of two-thirds of stockholders was required to amend other by-laws, sell the company, or issue stock for a five-year period; (iii) Nabors was subject to a five-year standstill, during which it could not acquire additional shares or solicit acquisition proposals; and (iv) a violation of the standstill would provide a basis to terminate the employment of certain members of the post-merger management team affiliated with Nabors. The Court suggested, but did not decide, that the suite of protections negotiated for the benefit of C&J stockholders could “take the transaction out of the reach of Revlon,” but the Court was reluctant to so hold in the context of an expedited appeal. Of particular significance to the Court was the by-law ensuring the ability of C&J stockholders to share in any future control premium and that the by-law could not be repealed absent unanimous stockholder consent.
  • Not every alleged conflict involving a financial advisor is sufficient to call the sales process into question. The C&J-Nabors transaction initially was proposed by a Citi banker to C&J’s CEO, Joshua Comstock. Citi had also previously worked for Nabors and the banker who suggested the deal was a social acquaintance of Nabors’ CEO. C&J’s primary financial advisor was Goldman Sachs. When the companies began to negotiate, Nabors informed C&J that it wanted to use Goldman and suggested that C&J engage Citi. Comstock agreed, saying it was “the right thing to do” since Citi suggested the deal. The Court noted that Comstock admitted in his deposition that he felt that Citi was conflicted and that he felt that Citi was giving feedback to Petrello, Nabors’ CEO, causing him to believe that when he was negotiating with Citi, he was also negotiating with Nabors. The Supreme Court nonetheless held that the plaintiffs did not demonstrate a reasonable probability of success on the merits, suggesting that it was not persuaded sufficiently by the alleged conflict of interest.
    The Delaware courts have issued a number of decisions in the past several years, including In re Rural Metro Corp. Stockholders Litigation and In re Del Monte Foods Company Shareholders Litigation, critical of the conduct of financial advisors, including those based on undisclosed conflicts of interest. The Supreme and Chancery Courts’ decision here demonstrate that not every alleged conflict on the part of a financial advisor will rise to a level sufficient to call into question the board’s sales process. While Comstock’s “perception of needing to ‘negotiate’ with his own financial advisor” suggested that the “deal process fell short of the ideal,” that in and of itself did not justify a finding of a fiduciary duty breach by the C&J board, particularly where the conflict was by and large disclosed.
  • The C&J CEO’s pre-merger agreement negotiation of his post-closing compensation package did not constitute a fiduciary duty breach or create a conflict. Neither the lower court nor the Supreme Court found that Comstock’s efforts to secure an employment package as CEO of the combined entity rendered him conflicted or rose to the level of a fiduciary duty breach. Comstock’s compensation package was not part of the merger agreement, but was memorialized and endorsed in a side letter with Nabors’ CEO. Although acknowledging that his “focus” on his compensation “casts shade on his motivations, as he ultimately secured a generous package,” the Supreme Court pointed to a number of other facts undercutting such a conclusion. These included evidence that selling to a private equity buyer or purchasing another substantial asset had the potential to provide similar benefits for Comstock, he faced “no threat to his tenure” and held 10% of C&J’s outstanding common stock, giving him a “strong interest in maximizing the value of those shares.” In addition, the package was not binding on the board of New C&J, which had to approve it, and “most important[ly]” any potential conflict had to be “balanced against” the numerous communications between Comstock and the C&J board regarding the transaction and the “reality” that the board’s “favorable view” of the deal was validated by the stock market reaction, which drove C&J’s shares 20% higher in after-hours trading following the transaction announcement.
    The Court’s ruling on this issue reinforces two themes in recent Delaware fiduciary duty jurisprudence. First, as articulated in In re Comverge, Inc. Shareholders Litigation and In re: Crimson Exploration Inc. Stockholder Litigation significant stock ownership is a powerful argument against allegations that a director was conflicted or acted other than to maximize shareholder value. Second, the fact that Comstock’s compensation package was subject to approval by New C&J’s board (as well as C&J stockholders on an advisory basis) cut against the charge that Comstock was conflicted or breached fiduciary duties. A similar result was reached in Crimson, where the Chancery Court found that a large stockholder was not conflicted with respect to a merger transaction in part because certain side benefits negotiated by the stockholder with the acquirer were not part of the merger agreement itself even though they were “anticipated” at the time the agreement was signed. Again, this suggests that it may be advantageous to defer binding agreements on matters that may create a conflict until after a transaction is approved, although doing so carries associated risk of ultimately not securing the benefits.

To read the full opinion, please click here.

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