Tuesday, October 28, 2014

Entire Fairness Review Not Triggered Where Investment Firm Was Not Controlling Stockholder

[This story previously appeared in Securities Regulation Daily.]

By Lene Powell, J.D.

The Delaware Chancery court dismissed a shareholder challenge to the merger of two oil and gas companies, finding that entire fairness review was not triggered because an investment firm that controlled a third of the acquired company’s stock was probably not a controlling stockholder, and even if it were, had not engaged in a conflicting transaction. The court also concluded that the plaintiff shareholders did not sufficiently show bad faith on the part of the directors to survive the business judgment rule (In re Crimson Exploration Inc. Stockholder Litigation, October 24, 2014, Parsons, D.)

Background. Contango Oil & Gas Co. (Contango) and Crimson Exploration, Inc. (Crimson) were both independent natural gas and oil companies headquartered in Houston, Texas. Contango, the acquiring company, sought to diversify its asset base, while Crimson was looking for more working capital to exploit its existing opportunities and increase growth. Many members of Crimson’s management expected positions in the new company.

Oaktree Capital Management, L.P. is an investment management firm that held about 33.7 percent of Crimson’s outstanding shares before the merger. The plaintiff shareholders alleged that a group of affiliated defendants, including Oaktree, constituted controlling stockholders of Crimson and breached their fiduciary duties by selling the company below market value for self-serving reasons. Specifically, they argued that Oaktree received significant side benefits not shared with the minority common stockholders, including an agreement by Contango to pay off a lien held by Oaktree (Prepayment) and a Registration Rights Agreement (RRA) allowing it to sell its stock in the combined entity in a private placement. The plaintiffs challenged the merger on the grounds of inadequate process, inadequate price, and inadequate disclosure.

Unlikely that investment firm was a controlling stockholder. Under Delaware law, entire fairness review may be triggered when a controlling stockholder engages in a conflicting transaction. The court first examined whether Oaktree was a controlling stockholder of Crimson.

The court rejected the contention that Oaktree, executive officers, and the Crimson board together represented a control group that controlled 52.15 percent of the vote. Under Delaware law, multiple stockholders together can constitute a control group, with each of its members subject to the fiduciary duties of a controller. However, the alleged members of a control group must be connected in some legally significant way to work together toward a shared goal, such as by contract, common ownership, agreement, or other arrangement. The plaintiffs failed to meet that element, as they did not show that the executive whose shares they sought to include signed any voting agreement, or that there was any agreement, formal or otherwise, between Oaktree and a shareholder that held about 15 percent of Crimson’s common stock. The simple fact that the interests of two entities were aligned was not legally sufficient to establish the existence of a control group, said the court.

Next, the court dismantled the plaintiffs’ overarching theory that Oaktree sought to exit its investment in Crimson, and thus was willing to undersell its shares. Oaktree would suffer the most from a low merger price, given its holdings of over 15.5 million shares, and thus would need to secure significant side benefits to overcome that loss. Inferring that Crimson’s management would favor their own interests over those of the stockholders was inconsistent with Oaktree’s alleged control over management, because management’s successfully securing new corporate perquisites in that way would not advance Oaktree’s interests. The court concluded that there were no specific allegations from which it could reasonably infer that Oaktree, alone or in combination with others, actually exercised control over Crimson or the negotiation of the merger.

No conflicting transaction. Even drawing all inferences in the plaintiffs’ favor and assuming that Oaktree did control Crimson, the court concluded that entire fairness review still did not apply. The plaintiffs had alleged that Oaktree “competed” for consideration with Crimson’s minority stockholders, alleging a combination of disparate consideration (the Prepayment) and receipt of a unique benefit (the RRA), constituting a conflicting transaction triggering entire fairness review.

Side deals between an acquirer and a controller, which the board did not approve and to which the corporation is not a party, do not implicate entire fairness, said the court. Regarding the Prepayment, at the time the merger was signed, there was no agreement to repay the debt early. Even though the Prepayment was anticipated, mere anticipation is not equivalent to having a term in a definitive merger agreement. There were no allegations that the Crimson board was involved in negotiating or approved the debt repayment as part of the merger agreement. Furthermore, the court doubted that the 1 percent prepayment fee would compensate Oaktree sufficiently to cause it to take a lower price for its shares.

As to the RRA, it was not part of the actual merger agreement and was not alleged to have been approved by the Crimson board, so it did not qualify as additional consideration. Moreover, it did not confer a unique benefit on Oaktree. The court found unconvincing plaintiffs’ contention that Oaktree was motivated by a need for liquidity. If Oaktree wanted to exit its investment, the obvious method would be a cash-out merger, not a stock-for-stock transaction. Oaktree did not propose the transaction or attempt to spring it on the board; rather, Crimson’s CEO and another executive began the negotiations with Contango and then contacted Oaktree.

The court also rejected allegations that the Crimson board lacked independence. None of the directors worked for, held stock in, or had any other disqualifying relationship with Contango. The only colorable challenge with any reasonable traction was to Crimson’s CEO. At least four members of the board, and possibly as many as six—in either case, a majority—were independent and disinterested in approving the merger.

No bad faith. Having found that Oaktree, if a controller, was not conflicted and that a majority of the board was disinterested and independent, the court concluded that the Crimson board’s decision to enter into the merger was protected by the business judgment rule unless the board had acted in bad faith. The plaintiffs did not meet this pleading standard.

Regarding the merger price, there was no rule that a low premium represents a bad deal, much less bad faith. The plaintiffs failed to allege that a higher price reasonably was available or that there was another bidder ready and willing to buy Crimson for a higher price. The court also declined to conclude that a $117 million accounting impairment was suspicious or that the valuation method was flawed and unreliable.

Because the underlying breaches of fiduciary duty were dismissed, the claim that Contango aided and abetted breaches of fiduciary duty failed as well.

The case is No. 8541-VCP.