Delaware Court of Chancery Applies Business Judgment Rule to Directors Who Approve Merger Supported by Large Shareholders
20 November 2014
In its October 24, 2014, decision in In re Crimson Exploration Inc.
Stockholder Litigation, C.A. No. 8541, the Delaware Court of Chancery
confirmed that the business judgment rule is applicable in evaluating claims for
breach of fiduciary duty asserted against directors who approve a merger that is
supported by and favorable to large shareholders. The court held that such
transactions will be reviewed under the business judgment rule, rather than the
entire fairness standard, unless both of the following
factors are present: (1) the large shareholder is actually a “controller” of the
target, and (2) the controller is actually conflicted.
The court provided important guidance as to the factors that might cause a large shareholder to be considered a controller and a controller to be considered conflicted.
Background This case arose from the April 2013 stock-for-stock purchase of Crimson Exploration, Inc., an oil and gas company, by Contago Oil & Gas Co. Oaktree Capital Management, L.P. held approximately 33.7 percent of Crimson’s outstanding shares, and an Oaktree affiliate owned a significant portion of Crimson’s outstanding debt. The complaint also alleged a longstanding relationship between Oaktree and Crimson’s president and CEO. As side consideration to the merger, Oaktree sought and obtained a Registration Rights Agreement (RRA) so that it could sell its stock in the new entity in a private placement. Contago also agreed to pay off much of Crimson’s debt, including Oaktree’s portion, and paid a 1 percent prepayment penalty in order to do so.
Plaintiff shareholders sued, alleging that Crimson’s directors breached their fiduciary duties in approving the merger by accepting a purportedly inadequate price for the company. According to plaintiffs, Oaktree wanted the transaction undervalued for self-serving reasons. In particular, the plaintiffs alleged that Oaktree sought and obtained side consideration from Contago (the RRA and the prepayment of Crimson’s debts) in exchange for a lower purchase price. Plaintiffs further alleged that Crimson’s directors approved this plan because they were beholden to Oaktree, which was Crimson’s controlling stockholder.
Plaintiffs argued that the merger should be reviewed under the entire fairness standard, rather than the business judgment rule, because Oaktree was Crimson’s controller and dominated the board, and Oaktree’s interests were conflicted. Defendants disputed each of these points and moved to dismiss.
Control The court first considered whether Oaktree was truly a controlling stockholder of Crimson. Although Oaktree owned only 33.7 percent of Crimson’s shares, the court observed that “[e]xceeding the 50% mark . . . is only one method of determining whether a stockholder controls the company. A stockholder who exercises control over the business affairs of the corporation also qualifies as a controller.” Opinion at 24 (quotation omitted).
After surveying 10 cases where shareholders owned between 49 percent and 27.7 percent of the companies at issue, the court concluded that “a large blockholder will not be considered a controlling stockholder unless they actually control the board’s decisions about the challenged transaction.” Id. at 29. This “actual control test,” Id. at 24, could be satisfied through a showing that certain personalities “literally dominated,” Id. at 29, other board members, including through threats or intimidation. But “[a]bsent a significant showing” of such dominance, “the courts have been reluctant to apply the label of controlling stockholder – potentially triggering fiduciary duties – to large, but minority, blockholders.” Id. at 29-30.
Plaintiffs in this case also alleged that other shareholders, together with Oaktree, formed a control group. The court held that “multiple stockholders together can constitute a control group, with each of its members being subject to the fiduciary duties of a controller,” if the relevant stockholders are “connected in some legally significant way,” such as by agreement, rather than just “mere concurrence of self-interest among certain stockholders.” Id. at 37-38.
The court held that plaintiffs in this case did not sufficiently allege that Oaktree and others formed a control group, rather than simply sharing common interests. With respect to whether Oaktree, by itself, controlled Crimson, the court expressed significant skepticism, but – given the procedural posture of the motion to dismiss – declined to rule on this point.
Conflict of Interests Even if a shareholder is deemed to be controlling, the court explained, entire fairness review is not triggered unless the controller was conflicted with regard to the transaction at issue. In particular, the court held that there are two categories of conflicted transactions: “(a) transactions where the controller stands on both sides; and (b) transactions where the controller competes with the common stockholders for consideration.” Id. at 30.
The first category could include situations where the controller of the target also had an interest in the acquirer, or where the controller buys out other shareholders. In the second category, the court identified three subcategories:
fairness review.
First, the court refused to consider the prepayment as disparate consideration for the merger, because at the time the merger was signed, there was no agreement for Contago to pay Crimson’s debt. The court held that “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.” Id. at 44.
The court also rejected plaintiffs’ theory that Oaktree pressured the board to accept a dramatically reduced purchase price because Oaktree wanted to obtain for itself the benefits of the prepayment and the RRA. This theory made little sense, the court reasoned, because the value of these benefits to Oaktree would have been dwarfed by the loss in value to Oaktree, as a holder of more than 15.5 million shares, had the purchase price been artificially depressed. Plaintiffs argued, in response, that the RRA was particularly valuable because it would have provided Oaktree with the ability to sell many of its shares at a time when it needed liquidity. The court discounted this argument because, in the absence of a crisis situation or a fire sale, there was no clear indication that Oaktree’s need for liquidity was so acute that it would prefer the relatively low cash value of the RRA over the potential for a significantly higher aggregate share price if the merger consideration were not artificially depressed.
Accordingly, the court held that Oaktree, even if it was a controlling shareholder, was not conflicted by the merger; instead, its overall goal – to maximize the value of its shares – was the same as that of all other shareholders. Thus, the court declined to subject the merger to an entire fairness review.
Other Rulings Regardless of any shareholders’ status or actions, the entire fairness standard would still apply if a majority of the directors themselves were not disinterested and independent, and of course the presumptions of the business judgment rule could also be rebutted if the directors acted in bad faith. The court held that the plaintiffs’ allegations were insufficient to establish either of those exceptions.
The court further held that any remaining duty of care claims could not survive the exculpatory clause in Crimson’s certificate of incorporation, and that the aiding and abetting claims against Contago and against Crimson’s merger subsidiary were also dismissible. Finally, in light of its ruling on the motion to dismiss, the court denied a motion to intervene filed by another Crimson shareholder.
Conclusion Crimson Exploration illuminates the standard that will be applied in evaluating the duties of a large, minority shareholder, and the duties of directors serving on the boards of such corporations. Crimson Exploration makes clear that the courts will continue to apply the business judgment rule unless the large shareholder both qualifies as a controller and is actually conflicted.
The court provided important guidance as to the factors that might cause a large shareholder to be considered a controller and a controller to be considered conflicted.
Background This case arose from the April 2013 stock-for-stock purchase of Crimson Exploration, Inc., an oil and gas company, by Contago Oil & Gas Co. Oaktree Capital Management, L.P. held approximately 33.7 percent of Crimson’s outstanding shares, and an Oaktree affiliate owned a significant portion of Crimson’s outstanding debt. The complaint also alleged a longstanding relationship between Oaktree and Crimson’s president and CEO. As side consideration to the merger, Oaktree sought and obtained a Registration Rights Agreement (RRA) so that it could sell its stock in the new entity in a private placement. Contago also agreed to pay off much of Crimson’s debt, including Oaktree’s portion, and paid a 1 percent prepayment penalty in order to do so.
Plaintiff shareholders sued, alleging that Crimson’s directors breached their fiduciary duties in approving the merger by accepting a purportedly inadequate price for the company. According to plaintiffs, Oaktree wanted the transaction undervalued for self-serving reasons. In particular, the plaintiffs alleged that Oaktree sought and obtained side consideration from Contago (the RRA and the prepayment of Crimson’s debts) in exchange for a lower purchase price. Plaintiffs further alleged that Crimson’s directors approved this plan because they were beholden to Oaktree, which was Crimson’s controlling stockholder.
Plaintiffs argued that the merger should be reviewed under the entire fairness standard, rather than the business judgment rule, because Oaktree was Crimson’s controller and dominated the board, and Oaktree’s interests were conflicted. Defendants disputed each of these points and moved to dismiss.
Control The court first considered whether Oaktree was truly a controlling stockholder of Crimson. Although Oaktree owned only 33.7 percent of Crimson’s shares, the court observed that “[e]xceeding the 50% mark . . . is only one method of determining whether a stockholder controls the company. A stockholder who exercises control over the business affairs of the corporation also qualifies as a controller.” Opinion at 24 (quotation omitted).
After surveying 10 cases where shareholders owned between 49 percent and 27.7 percent of the companies at issue, the court concluded that “a large blockholder will not be considered a controlling stockholder unless they actually control the board’s decisions about the challenged transaction.” Id. at 29. This “actual control test,” Id. at 24, could be satisfied through a showing that certain personalities “literally dominated,” Id. at 29, other board members, including through threats or intimidation. But “[a]bsent a significant showing” of such dominance, “the courts have been reluctant to apply the label of controlling stockholder – potentially triggering fiduciary duties – to large, but minority, blockholders.” Id. at 29-30.
Plaintiffs in this case also alleged that other shareholders, together with Oaktree, formed a control group. The court held that “multiple stockholders together can constitute a control group, with each of its members being subject to the fiduciary duties of a controller,” if the relevant stockholders are “connected in some legally significant way,” such as by agreement, rather than just “mere concurrence of self-interest among certain stockholders.” Id. at 37-38.
The court held that plaintiffs in this case did not sufficiently allege that Oaktree and others formed a control group, rather than simply sharing common interests. With respect to whether Oaktree, by itself, controlled Crimson, the court expressed significant skepticism, but – given the procedural posture of the motion to dismiss – declined to rule on this point.
Conflict of Interests Even if a shareholder is deemed to be controlling, the court explained, entire fairness review is not triggered unless the controller was conflicted with regard to the transaction at issue. In particular, the court held that there are two categories of conflicted transactions: “(a) transactions where the controller stands on both sides; and (b) transactions where the controller competes with the common stockholders for consideration.” Id. at 30.
The first category could include situations where the controller of the target also had an interest in the acquirer, or where the controller buys out other shareholders. In the second category, the court identified three subcategories:
(1) “‘disparate consideration’ cases,” Id. at 31, where the controller receives greater consideration for the merger than minority shareholders do;Here, plaintiffs alleged a combination of “disparate consideration” (the prepayment of debt) and a “unique benefit” (the RRA). The court held that these allegations were insufficient to prompt an entire
(2) “‘continuing stake’ cases,” Id. at 32, where the controller receives continuing equity in the surviving entity; and
(3) “‘unique benefit’ cases,” Id. at 33, where the controller receives some other sort of benefit that is not shared with other stockholders.
fairness review.
First, the court refused to consider the prepayment as disparate consideration for the merger, because at the time the merger was signed, there was no agreement for Contago to pay Crimson’s debt. The court held that “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.” Id. at 44.
The court also rejected plaintiffs’ theory that Oaktree pressured the board to accept a dramatically reduced purchase price because Oaktree wanted to obtain for itself the benefits of the prepayment and the RRA. This theory made little sense, the court reasoned, because the value of these benefits to Oaktree would have been dwarfed by the loss in value to Oaktree, as a holder of more than 15.5 million shares, had the purchase price been artificially depressed. Plaintiffs argued, in response, that the RRA was particularly valuable because it would have provided Oaktree with the ability to sell many of its shares at a time when it needed liquidity. The court discounted this argument because, in the absence of a crisis situation or a fire sale, there was no clear indication that Oaktree’s need for liquidity was so acute that it would prefer the relatively low cash value of the RRA over the potential for a significantly higher aggregate share price if the merger consideration were not artificially depressed.
Accordingly, the court held that Oaktree, even if it was a controlling shareholder, was not conflicted by the merger; instead, its overall goal – to maximize the value of its shares – was the same as that of all other shareholders. Thus, the court declined to subject the merger to an entire fairness review.
Other Rulings Regardless of any shareholders’ status or actions, the entire fairness standard would still apply if a majority of the directors themselves were not disinterested and independent, and of course the presumptions of the business judgment rule could also be rebutted if the directors acted in bad faith. The court held that the plaintiffs’ allegations were insufficient to establish either of those exceptions.
The court further held that any remaining duty of care claims could not survive the exculpatory clause in Crimson’s certificate of incorporation, and that the aiding and abetting claims against Contago and against Crimson’s merger subsidiary were also dismissible. Finally, in light of its ruling on the motion to dismiss, the court denied a motion to intervene filed by another Crimson shareholder.
Conclusion Crimson Exploration illuminates the standard that will be applied in evaluating the duties of a large, minority shareholder, and the duties of directors serving on the boards of such corporations. Crimson Exploration makes clear that the courts will continue to apply the business judgment rule unless the large shareholder both qualifies as a controller and is actually conflicted.