Tuesday, April 09, 2019

‘Substantive economic dealings’ in advance of procedural protections necessitates further review

By Amy Leisinger, J.D.

The Delaware Supreme Court has affirmed in part and reversed in part the Chancery Court’s dismissal of a complaint alleging that certain oil and gas companies and their executives caused stockholders to approve an unfair transaction based on a misleading proxy statement. According to the court, the Court of Chancery correctly held that the complaint failed to state a disclosure claim, but the complaint should not have been dismissed in its entirety, as intervening case law has provided that dismissal is not warranted if a complaint has pleaded facts supporting a reasonable inference that companies engaged in substantive economic negotiations before required procedural protections have been put in place. The court remanded the matter to the Chancery Court for further consideration (Olenik v. Lodzinski, April 5, 2019, Seitz, C.).

Dismissal, intervening law. According to the Chancery Court, the business judgment rule applied to the transaction to combine Bold Energy with Earthstone Energy because it was structured to comply with the conditions set forth in Kahn v. M&F Worldwide Corp. (MFW). The proxy statement informed the stockholders of all material facts about the transaction, and, although, the parties worked on the transaction for months before Earthstone’s special committee extended an offer with the MFW conditions, those interactions “never rose to the level of bargaining,” the court stated. EnCap Investments (formerly the controller of Earthstone through Oak Valley Resources) and Earthstone preconditioned the deal on MFW’s requirements in an August 19, 2016, letter, the special committee was well functioning, and the stockholder vote was informed and not coercive, according to the court. As such, the court found, the MFW protections applied, and the transaction was subject to business judgment deference, which, in turn led in dismissal.

However, while the matter was on appeal, the Delaware Supreme Court decided Flood v. Synutra International, Inc. under which the court held that, to invoke the MFW protections in a controller-led transaction, the controller must “self-disable” using the MFW conditions prior to the start of “substantive economic negotiations.” The court noted that MFW protections will not result in dismissal in connection with the business judgment rule when a complaint has adequately pleaded facts supporting a reasonable inference that the procedural protections were not put in place early and before the commencement of substantive economic negotiations.

Substantive economic negotiations existed. The court noted that, in mid-2015, EnCap began looking for ways to sell Bold and retained an investment banker to determine whether there was a market for sale. Earthstone was pursuing a number of acquisitions, which led to its interest in a transaction. Discussions went on for several months and a substantial amount of information was exchanged, the court stated. Earthstone management met with multiple investment banks, and the Earthstone board met several times to discuss the potential transaction. “While some of the early interactions could qualify as preliminary discussions,” the court explained, “the complaint support[s] a pleading stage inference that the preliminary discussions transitioned to substantive economic negotiations when the parties engaged in a joint exercise to value Earthstone and Bold.” The MFW procedural protections and the involvement of the special committee were not put in place until after almost eight months of substantive economic dealings and negotiations concerning of the financial play between the among the parties, the court found.

“MFW protections must be established ‘up front’ if they are to serve as a ‘potent tool to extract good value for the minority,’” the court stated, and Synutra clarified that MFW is not satisfied if a controller has not accepted that a transaction will not move forward without special committee and disinterested stockholder approval “early in the process and before there has been any economic horse trading.”

Further rejecting the defendants’ argument that EnCap was no longer a controller by the time of the transaction, the court reversed the Chancery Court’s dismissal of the claims for breach of fiduciary duties and remanded for consideration of the application of Synutra. The court did, however, affirm dismissal of the complaint’s disclosure claim, noting that the proxy disclosed financials showing that Bold was “distressed and needed to sell.”

The case is No. 392, 2018.