Author: Dan Stroh, Associate Member, University of Cincinnati Law Review
In recent years, Delaware courts have decided several important cases regarding the appropriate standard of review to apply when minority shareholders challenge actions taken by controlling shareholders.[1] In In re Crimson Exploration, the Delaware Court of Chancery created a clarifying framework for courts to analyze the propriety of shareholder involvement and control in the context of a corporate merger.[2] Merger transactions between large companies occur on a regular basis,[3] making any significant decision in this field very important, because the ability of shareholders to protect their interests is paramount in this area of business. The court’s decision clarified that shareholder “control” will be determined on an ad hoc basis, applying all relevant facts and circumstances, and it provided guidance as to when to apply “entire fairness” scrutiny to a board of directors’ decisions. Because corporate law decisions from Delaware are highly regarded due to the large number of corporations that choose to incorporate within the state,[4] the Court of Chancery’s Crimson decision will likely have significant implications for corporate law across the country.
The Beginning of the Crimson Litigation
In Crimson, Contango Oil & Gas acquired Crimson Exploration in a stock-for-stock merger.[5] To pay for the acquisition, Contango exchanged shares of their corporation in return for Crimson paying a premium over the market price of Crimson shares.[6] After the merger, the previous shareholders of Crimson were to own approximately 20% of Contango, due to the exchange of stock.[7] After review by an outside advisor, Crimson’s board of directors approved this agreement.[8] Shortly after the board approved the merger agreement, the board negotiated a Registration Rights Agreement[9] (RRA) and early pay-off of a loan, including a prepayment penalty as terms of the approval.[10]
Prior to the merger, an investment management fund, Oaktree Capital Management, owned approximately 33.7% of Crimson shares. In addition, Oaktree controlled negotiations for the RRA and an Oaktree affiliate held the loan to be paid off, and thus received the prepayment penalty.[11] Following completion of the merger, Crimson minority shareholders brought a derivative suit, alleging that Oaktree controlled Crimson’s board of directors, resulting in a diminished price for the stock purchase.[12] Furthermore, the plaintiffs claimed that: the price was lower than what should have been paid as a fair price because Oaktree was serving its own interest over the corporation’s; several directors negotiated for better employment agreements during the merger process, also reflecting a self-interest neglecting the corporation; and several side deals benefitted Oaktree, while common shareholders received no equal benefit.[13]
Tiers of Scrutiny in Shareholder Litigation
There are two main tiers of scrutiny courts use when analyzing corporate transactions: the business judgment rule (BJR) and entire fairness review (EFR).[14] The BJR requires that the court look only at whether the corporation’s decisionmakers came to their decision in a reasonable manner.[15] If the directors of a corporation voting on the transaction approached the decision as a reasonable person would in the situation, the court will defer to the “business judgment” of the corporation, allowing the corporation to act its best interests. In contrast, the EFR standard examines the decision much more closely. Usually applied when there is a shareholder controlling more than 50% of the voting shares of a corporation involved in a transaction, EFR requires the court to examine the decision in the strictest manner possible, determining whether all aspects of the decision were fair to all parties.[16] Under this standard, the concepts of fair dealing and fair price are examined closely, ensuring that a minority shareholder is protected in the highest way possible.
In lawsuits involving minority shareholders challenging a transaction, the standard of review is vital. The business judgment standard is extremely deferential to the decisions of the board and thus makes a plaintiff’s chance of success very low. However, if the court reviews the decision under the entire fairness standard, the plaintiff’s chance of success dramatically increases. Thus, the standard of review is one of the most important factors of a shareholder litigation claim. To compel entire fairness review, the Crimson court held that a controlling shareholder must be a major party in the transaction and must have received consideration different from that of other shareholders. Thus, for the Crimson merger to merit entire fairness review, Oaktree must have controlled the activities of the Crimson board and received some form of compensation or benefit different from that other shareholders received.
To Apply or Not to Apply, the Amount of Control Is the Question
To determine what constitutes control under Delaware law, the court looked to precedent in which a shareholder held a significant portion of stock, but less than 50%. After reviewing these cases, the court stated, “the cases do not reveal any sort of linear, sliding-scale approach whereby a larger share percentage makes it substantially more likely that the court will find the stockholder was a controlling stockholder.”[17] Outside factors that influenced the decisions included: designation of a majority of board members; domination of control by a single family; whether the shareholders acted passively or aggressively; and whether the shareholders appeared to be acting out of self-interest.[18] However, the court determined that these factors are not exclusive and must be considered in light of the situation as a whole.
The court then moved to a discussion of the facts in Crimson. Applying the facts present, the Crimson court determined that it was conceivable that Oaktree controlled the board.[19] In so holding, the court considered a multitude of factors. The make-up of the board was especially important. Several members of Crimson management had ties to Oaktree or had been installed in important positions after Oaktree’s investment.[20] The plaintiffs claimed, and the court noted, that due to this involvement, board members favorable to Oaktree may have taken part in the decision.[21] In addition, some of the management and board members were involved with Oaktree prior to the presentation of the merger to the complete board.[22] Through the use of the facts and circumstances test, set out by the court in its “sliding-scale” analysis, the court determined it was conceivable that Oaktree was a controlling shareholder drawing all reasonable inferences in favor of the plaintiff.[23]
The key determinations in the court’s analysis are not unique to Crimson. Past decisions accounted for a multitude of factors when determining whether or not shareholder control existed. In holding that the test for control depends on these factors and all other situational elements present, the court properly determined that any test for control needs to be one of facts and circumstances. Any rigid test requiring certain metrics or numerical definition would not be able to properly determine “actual control.” By allowing ad hoc decisions, the court provided flexibility to consider all relevant facts and circumstances when determining if shareholder control is present.
Oaktree’s Additional Compensation and Benefits
The Court of Chancery provided a framework for determining when a controlling shareholder receives more consideration than minority shareholders. If a plaintiff can show that the controlling shareholder received additional consideration in one of the three categories set out by the court, then EFR applies. The Crimson decision defined three distinct categories: disparate consideration, continuing stake, and unique benefit.[24] For a court to apply EFR, there must be a controlling shareholder and additional consideration in only one of these three categories. Disparate consideration involves a controlling shareholder receiving consideration greater than that of the minority shareholders.[25] In a continuing stake scenario, the controller receives a continuing equity in the surviving entity while minority shareholders are cashed out.[26] The unique benefit category is met if all shareholders appear to receive pro rata consideration but there is some other sort of benefit conferred upon the controller separate from minority shareholders.[27]
In Crimson, the court found that none of these situations were present. The plaintiffs alleged a combination of disparate consideration and unique benefits in the form of the prepayment and RRA, respectively.[28] Outside of these two factors, Oaktree received the exact compensation that all other shareholders received in the transaction.[29] The comparatively minimal aspects of these factors were not enough to convince the court that they would override the normal incentive for a large shareholder to maximize its compensation from the stock-for-stock swap.[30] In addition, the court noted that both the RRA and the prepayment were negotiated after the merger agreement had been approved by shareholders.[31]
While this is the first decision to set out the test providing plaintiffs with three options to show additional consideration or benefits, the court’s application of this framework is logical and helps to clarify when entire fairness will be used to review a transaction. As corporate law evolves and the corporate landscape grows, the guidance provided by the Crimson court allows corporations and their attorneys to know what is legal protocol in the context of a merger or acquisition. So long as none of the three types of additional compensation or side deals set out by the court are present in a transaction, a corporation with a controlling shareholder would be free from the fear of long and expensive litigation. Instead, the corporation could rest easy knowing that a court would apply the BJR, just as the court did in Crimson, effectively putting an end to a derivative lawsuit. It is important to note that the court singled out the RRA and prepayment penalty as happening after the merger agreement. It is possible that this leaves a loophole for a company to exploit in the future. While the clearly delineated structure of the test helps to clear up what will implicate an entire fairness review in the future, the courts eventually will need to address the possibility of greater consideration in side deals negotiated after approval of a transaction.
The Clarification of When to Apply EFR Benefits Corporations and Shareholders
The Crimson decision clarified how to test for shareholder control in a corporate transaction. By holding that review for a controlling shareholder is determined on an ad hoc basis, the court avoided imposing a rigid empirical structure that would limit a court’s ability to review the context of each situation. While the court did not decide the issue in Crimson, it is apparent that courts will consider a number of factors in future cases. The continued application of a facts and circumstances test creates flexibility for courts faced with an alleged controlling shareholder. By considering all factors, the court balances the interests of a large shareholder in maximizing profit with protecting smaller shareholders in the case of an overbearing controller. The court also set out a framework for determining what constitutes a conflicted transaction in the absence of self-dealing by a controlling shareholder. Clarity in this area provides corporations and their attorneys guidance that may be used to structure mergers in a way to avoid the possibility of expensive litigation.
In addition, Crimson also made clear when a minority shareholder plaintiff deserves an entire fairness review of a corporate transaction. While it is likely that the court will need to revisit the possible loophole of side deals or benefits negotiated after approval of a merger left by Crimson, the structure provided sets out an important standard on when entire fairness will apply to a transaction reviewed by the court. Setting out a clear interpretation of these issues, the court provided better guidance for attorneys on both sides of shareholder suits. Plaintiffs have a clearer picture of what they need to show to demand an entire fairness review, while attorneys for corporations can avoid the possibility of a suit by studying the clarification offered by the chancery court. Consequently, the decision in Crimson should reduce confusion for both parties in shareholder suits in the future.
[1] See In re KKR Financial Holdings LLC Shareholder Litigation, C.A. No. 9210-CB, 2014 Del. Ch. LEXIS 207 (Del. Ch. Oct. 14, 2014), In re Tele-Communications, Inc. S’holders Litig., C.A. No. 16470, 2005 Del. Ch. LEXIS 206 (Del. Ch. Jan. 10, 2006), In re Delphi Fin. Gp. S’holder Litig., C.A. No. 7144-VCG, 2012 Del. Ch. LEXIS 45,, (Del. Ch. Mar. 6, 2012), In re John Q. Hammons Hotels Inc. S’holder Litig., C.A. No. 758-CC, 2009 Del. Ch. LEXIS 174, (Del. Ch. Oct. 2, 2009).
[2] In re Crimson Exploration Inc. Stockholder Litig., C.A. No. 8541-VCP, 2014 WL 5449419, (Del. Ch. Oct. 24, 2014).
[3] In the first six months of 2014, over 12,000 deals have been announced with a value nearing $1.77 trillion. Michael J. De la Merced, Mergers Hit a 7-Year High, Propelled by a Series of Blockbuster Deals, N.Y. Times DealBook, (June 30, 2014, 8:13 PM) http://dealbook.nytimes.com/2014/06/30/propelled-by-a-series-of-blockbuster-deals-mergers-hit-a-7-year-high/.
[4] Although it is a very small state, Delaware wields a great amount of power in the corporate law landscape as Delaware is the corporate home for 64% of Fortune 500 companies and more than 50% of all publicly traded companies. About Agency, State of Delaware, http://www.corp.delaware.gov/aboutagency.shtml, (last visited Nov. 18, 2014).
[5] Crimson at *6. In a stock-for-stock merger, the acquiring company pays for the purchase by providing shares of its corporation to the target company at a specified ratio.
[6] Id.
[7] Id.
[8] Id.
[9] A Registration Rights Agreement (RRA) created requires an acquiring company to register the securities used in the merger, allowing investors to more easily trade the shares.
[10] Crimson at *6.
[11] Id.
[12] A derivative suit is one in which shareholders bring the suit on behalf of the corporation alleging that harm was caused to the corporation itself, generally through some sort of mismanagement or a decision made by the board in which.
[13] Crimson at *6.
[14] Id. at *8.
[15] Id. at *9.
[16] Id.
[17] Id. at *10.
[18] Id. at *10-12.
[19] Id. at *12. Although it was deemed conceivable, the chancellor did hint it was unlikely that there would be a finding of control.
[20] Id. at *15-16.
[21] Id.
[22] Id.
[23] Id. at 17.See supra Note 19.
[24] Id. at *14.
[25] Id. at *12.
[26] Id. at *13.
[27] Id. at *14. See In re Primedia Inc., 67 A.3d 455, 482 (Del. Ch. 2013). (Elimination of a possible derivative claim that could cost the controller $80 million was a unique benefit.)
[28] Crimson at *17-18.
[29] Id. at *18.
[30] Id. at *19-20.
[31] Id. at *18-19.
