Delaware Supreme Court provides important additional guidance for controlling stockholders wishing to qualify their transactions for a more favorable judicial review standard.
Valuation exercises that set the stage for future economic negotiations may be considered “substantive economic negotiations” under the MFW framework.
The absence of actual horse-trading or position-changing during preliminary discussions does not itself prove that substantive economic negotiations did not take place.
The relevant time for determining whether a stockholder is a controller is not at the time of invocation of the MFW protections, but rather at the time of substantive economic negotiations.
In the latest Delaware decision to expound MFW and the structuring of controller transactions, the Delaware Supreme Court clarified the requirement for a controlling stockholder to condition its offer “up front” on MFW’s dual procedural protections in order to qualify the transaction for review under the deferential business judgment rule instead of the more rigorous entire fairness standard of review. Reversing the Delaware Court of Chancery on the issue, the Supreme Court held in Olenik v. Lodzinski1 that, at least for purposes of a motion to dismiss, the discussions around valuation and exchange of confidential information between controller and target company counted as “substantive economic negotiations” that rendered the later conditioning of the offer on the MFW protections ineffective, even though the parties had yet to engage in actual negotiations over terms.
The case centers around the merger of Bold Energy III LLC, a Texas LLC with substantial undeveloped oil and gas resources, and Earthstone Energy, Inc., a developer of oil and gas reserves. EnCap Investments L.P., a Delaware private equity and venture capital firm focusing on domestic oil and gas ventures, owned controlling interests in Bold and, until July 2016, Earthstone. EnCap controlled its investment in Earthstone through its holdings in Oak Valley Resources, LLC, a Delaware LLC founded by defendant Frank Lodzinski. Lodzinksi was appointed by EnCap to serve as the president and chief executive officer of Earthstone.
In mid-2015, EnCap began exploring options to sell Bold or take it public, but falling oil and gas prices rendered its initial efforts unsuccessful. Meanwhile, from 2014 through 2015, Earthstone had been pursuing a number of acquisitions, which led to its interest in Bold. Seeing an opportunity to combine Earthstone’s cash-generating business with Bold’s undeveloped resources, Lodzinski initiated discussions with EnCap about a possible Earthstone/Bold transaction, allegedly without first informing Earthstone’s board. From November 2015 through January 2016, Earthstone, Bold, EnCap and Lodzinski engaged in multiple conversations and meetings, which included: the sharing by Bold of financial information and data room access with Earthstone; a banker presentation to EnCap and Earthstone regarding Bold’s assets; and a meeting between Lodzinski, Earthstone and investment banking firms regarding valuation of Bold’s assets. Discussions were put on hold in early 2016 due to low oil prices but resumed in April 2016. From April until July 2016, Lodzinski led substantive financial discussions among EnCap, Earthstone and Bold about a potential transaction, including presentations regarding equity valuation models for Bold and further review of Bold’s assets and operations.
In July 2016, almost eight months after the initial discussions regarding a potential Earthstone/Bold transaction, Earthstone’s independent directors began the process of forming a special committee to oversee the potential transaction. While the special committee was being formed, substantive discussions regarding the transaction continued. On July 29, 2016, the Earthstone board formally established the special committee. The special committee’s charter authorized the committee to negotiate a potential transaction with Bold, hire its own advisors, and reject the transaction if it saw fit to do so. The charter also provided that the full board would not approve a transaction with Bold without the special committee’s recommendation, yet it did not provide for any condition based on majority of the minority stockholders’ approval.
On August 19, 2016—three weeks after the formation of the special committee—the committee authorized Lodzinski to send an offer letter to Bold. The letter was the first communication between the parties to explicitly invoke the dual protections described in Kahn v. M&F Worldwide Corp.,2 conditioning the transaction on both (i) approval by the special committee and (ii) a majority of Earthstone’s disinterested stockholders. (That the letter came from the special committee and not the controller was not relevant, as EnCap controlled Earthstone and agreed with the special committee’s insistence on the MFW conditions.) The special committee and Earthstone board approved the Earthstone/Bold transaction on November 7, 2016, and Earthstone’s disinterested stockholders approved the transaction on May 9, 2017.
Olenik, an Earthstone stockholder, filed a complaint for breach of fiduciary duties against the Earthstone directors, EnCap and Oak Valley Resources as Earthstone’s controlling stockholders, and Lodzinski, and against the Bold entities for aiding and abetting the breaches of fiduciary duty. The defendants moved to dismiss the complaint, principally on the grounds that Earthstone had conditioned its offer on the MFW protections, thus qualifying the transaction for business judgment review under MFW. The Chancery Court granted the motion to dismiss, finding that (i) the transaction was properly preconditioned on MFW’s dual protections up front in the August 19 letter, notwithstanding that preliminary discussions had been ongoing for months, (ii) the special committee was well functioning, and (iii) the stockholder vote was informed and not coercive. Thus, pursuant to MFW, the Chancery Court applied the business judgment rule instead of the more rigorous entire fairness standard typically applicable to controller transactions and dismissed the complaint. Olenik appealed.
Substantive Economic Negotiations under the MFW Framework
The Supreme Court reversed the Chancery Court’s ruling in part, rejecting the Chancery Court’s finding that MFW’s dual protections had been established up front. While the Supreme Court acknowledged that preliminary discussions between a controller’s representatives and representatives of a controlled company do not “pass the point of no return for invoking MFW’s protections,”3 the Court held that the well-pled facts in the complaint supported a reasonable inference that the MFW protections had not been put into place before “substantive economic negotiations took place.”4
As the Court explained, under MFW, the business judgment rule governs transactions between a controlling stockholder and its controlled subsidiary (or, as in this case, between two controlled subsidiaries in a deal orchestrated by the controlling stockholder) when conditioned from the outset on (i) the approval of an independent, adequately empowered special committee that fulfills its duty of care and (ii) the uncoerced, informed vote of a majority of the minority stockholders.5 These dual MFW protections, if established “up front” or “from inception,” neutralize the controller’s influence, thus permitting the transaction to be reviewed under the same, deferential standard as arm’s-length transactions, instead of the less favorable entire fairness standard of review.6
A key factor, then, is the timing of the implementation of the MFW protections—when the protections can still be said to have been installed early enough to create an arm’s-length dynamic or when the discussions have been irretrievably tainted by the influence of the controlling stockholder. The Court addressed this “up front” requirement in Flood v. Synutra.7 In Synutra, the Court, taking what it called a “pragmatic approach,”8 held that the MFW requirements are satisfied when the controller conditions its offer “at the germination stage,” when the special committee is “selecting its advisors, establishing its method of proceeding, beginning its due diligence, and has not commenced substantive economic negotiations with the controller.”9
In Olenik, the Court held that the facts supported a reasonable inference that rather than conditioning the offer at the germination stage, the controllers had first “substantially negotiated the financial state of play”10 before setting the MFW conditions. In support of its decision, the Court highlighted the steps taken by the defendants before the eventual letter that invoked the MFW conditions, including:
EnCap sharing with Earthstone a presentation that EnCap’s investment bank had previously used to market Bold.
Earthstone and EnCap signing a confidentiality agreement governing the exchange of information about Bold, followed by Earthstone receiving access to a data room and confidential financial and technical information about Bold.
Meetings between Earthstone management and three investment banks to get their views on Bold’s valuation.
Continued meetings between Earthstone management and EnCap to discuss a deal for Bold, plus additional on-site due diligence.
Delivery from Earthstone to EnCap of two separate valuation presentations, the first indicating an equity valuation of Bold of approximately $305 million, and the second raising its valuation to approximately $335 million.
While the Court acknowledged that some of the early interactions between Earthstone and EnCap were mere preliminary discussions that had not commenced too far for MFW’s ab initio requirement, the facts supported a reasonable inference that the preliminary discussions became substantive economic negotiations when the parties engaged in a joint exercise to value Earthstone and Bold. The Court emphasized that Earthstone’s valuation presentations likely “set the field of play for the economic negotiations to come” by fixing the range of any offers or counteroffers. Indeed, future negotiations centered on these valuation ranges, culminating with Earthstone management proposing a transaction to its board with an already presumed timeline and an assumed price of $333 million, nine days before the August 19 letter to Bold was sent.
Since Olenik had pled facts supporting a reasonable inference that the MFW protections were not put in place up front and before substantive economic negotiation took place, the Court ruled that the Chancery Court should not have applied the business judgment rule, and the complaint should not have been dismissed on MFW grounds.
The Supreme Court’s decision in Flood v. Synutra first shed light on MFW’s “up front” requirement when it explained that the MFW conditions do not have to be set before any discussions between controller and target company begin, as long as the conditions are imposed at an early stage. The Olenik decision, like Flood v. Synutra, does not establish a bright-line test for the up-front requirement, but it does provide additional guidance to dealmakers and counsel to understand the extent to which preliminary discussions can proceed without losing the possibility of qualifying the transaction for business judgment review. The critical stage under the Olenik analysis is engagement in a joint valuation exercise, especially one that appears to set the range for offers and counteroffers. Such discussions may be enough to support a pleading-stage inference that preliminary discussions became substantive economic negotiations.
Also potentially relevant to the analysis is the entry into a confidentiality agreement and commencement of due diligence on the target company. Though those steps may be less dispositive on their own than explicit discussions of valuation, in a fact-specific analysis they may be taken as signs that the parties had entered into substantive economic negotiations. Any such steps should be carefully considered by counsel if the parties aim to avoid entire fairness review.
To avoid an inference that substantive economic negotiations have commenced, parties to a controlling-stockholder transaction should be wary of taking any of these steps before setting the MFW conditions:
Sharing banker presentations containing target valuation analyses.
Entering into a confidentiality agreement enabling the sharing of confidential information.
Commencing significant due diligence, such as accessing a confidential data room.
Engaging in discussions over transaction valuation.
Parties to a transaction with a controlling stockholder should keep in mind that approval by a special committee and a majority of the minority stockholders is not mandatory in controller transactions; it is an option for lowering the court’s standard of review. Therefore, the parties should consider whether they wish to add the risk inherent in introducing a stockholder-vote requirement, even in light of the advantage of qualifying the transaction for business judgment review. If, as is common, the target board appoints a well-functioning special committee of independent directors to negotiate the transaction, the defendants will be able to shift the burden to the plaintiffs to prove that the transaction was unfair to the stockholders.11 However, if the parties do wish to qualify the transaction for business judgment review, they should promptly establish the MFW conditions. When, as in Olenik, months of preliminary discussions take place before procedural protections are instituted, the optics become difficult for a controlling stockholder to establish that no substantive negotiations took place.
Importantly, the Court rejected the argument that it was not too late for the parties to invoke the MFW conditions because they had yet to engage in horse-trading by changing their position on any issue before the official offer letter was delivered. The fact that the valuation discussions had fixed the range in which offers and counteroffers would be made meant the parties had already anchored their positions to a certain extent. Therefore, controlling stockholders and target companies should be wary of engaging in discussions over valuation or in significant due diligence even when they do not explicitly bargain over deal terms. The absence of bargaining alone is insufficient.
Status as a Controller
The defendants asked the Court to affirm the Chancery Court’s decision on the alternative ground that EnCap was no longer a controller of Earthstone when the August 19 letter was delivered, since its indirect ownership of Earthstone had dropped to about 40%. The Court rejected this argument because ownership of less than a majority of a corporation’s voting power is not dispositive of determining control; a stockholder may also be deemed a controller if it has “effective control of the board” and “exercise[s] control over the corporation’s conduct.”12
The Court determined that the pleadings supported the inference that EnCap continued to control Earthstone after it had shed its majority interest. Earthstone had continued to describe itself in its public filings as a “company with a controlling shareholder” even after EnCap reduced its indirect ownership. EnCap also suffered a conflict of interest beyond the point at which it reduced its holdings in Earthstone, in light of Lodzinski’s leading role in the negotiations even as he had a long-term relationship with EnCap while at the same time negotiating his continued employment with Earthstone before the special committee was formed.
Additionally, the Court explained that while a controller can indeed sell down from its controller status, the status at the time the substantive economic negotiations occur is the relevant measurement date and not at the later time at which the MFW protections are invoked. In Olenik, substantive economic negotiations (including when Earthstone proposed the two valuations of Bold to EnCap) occurred prior to the point at which EnCap reduced its holdings. Therefore, the pleadings supported the reasonable inference that EnCap was Earthstone’s controlling stockholder while key economic negotiations were taking place.
It is well settled under Delaware law that a stockholder can be considered a controller without a majority interest in a corporation if it retains effective control of the board and exercises control over the corporation’s conduct. Thus, for a controlling stockholder to shed its controller status for purposes of avoiding entire fairness review, two conditions must be satisfied:
The stockholder must also relinquish effective control over the board and the corporation’s conduct. This determination is made on a case-by-case basis, but factors for determining control include board-designation rights, influence over individual board members, and taking an active role in the negotiations on both sides of the transaction.
The relinquishing of control and disposition of a majority interest must occur before substantive economic negotiations regarding the transaction take place. If these negotiations precede the controller relinquishing control and establishing the MFW-conditions, it is already too late.
1) Olenik v. Lodzinski, et al., 2019 WL 1497167 (Del. Apr. 5, 2019).
2) 88 A.3d 635 (Del. 2014).
3) Olenik, 2019 WL 1497167 at *8.
4) Id., quoting Flood v. Synutra Int’l, Inc., 195 A.3d 754, 764 (Del. 2018).
5) 88 A.3d at 644.
7) 195 A.3d 754 (Del. 2018).
8) 2019 WL 1497167 at *8.
9) 195 A.3d at 765.
10) 2019 WL 1497167 at *7.
11) Kahn v. Lynch Commc’n Sys. Inc., 638 A.2d 1110, 1117 (1994).
12) Corwin v. KKR Fin. Holdings LLC, 125 A.3d 304, 307 (Del. 2015).