The Delaware Supreme Court issued a decision last week that further clarifies when MFW’s “dual protections” must be put in place in order to qualify the transaction for deferential business judgment review.  See Olenik v. Lodzinski, No. 392, 2018 (Del. April 5, 2019).

Under MFW, business judgment review applies to a merger proposed by a controlling stockholder conditioned “ab initio” on two procedural protections: (1) the approval of an independent, adequately-empowered special committee that fulfills its duty of care; and (2) the uncoerced, informed vote of a majority of the minority stockholders.  If the controlling stockholder does not commit to these dual protections ab initio, i.e., from the beginning of negotiations, then the traditional entire fairness standard applies instead.[1]

As previously discussed on this blog (here), the Delaware Supreme Court recently provided significant guidance on the “ab initio” requirement in Flood v. Synutra International, Inc.[2]  In that case, the Court rejected a rigid interpretation of MFW’s timing requirement proposed by the plaintiffs that would have required the dual protections to be included in the controlling stockholder’s “first offer.”  Instead, the Court adopted a pragmatic approach that requires only that the dual protections be put in place “early in the process and before there has been any economic horse trading.”  Thus, even though the dual protections were not included in the controlling stockholder’s “first offer” in that case, the Court ruled that business judgment review applied because the dual protections were put in place “at the germination stage of the Special Committee process, when it [was] selecting its advisors, establishing its method of proceeding, beginning its due diligence, and ha[d] not commenced substantive economic negotiations with the controller.”

Unlike MFW and Synutra, the transaction at issue in Olenik was not a controlling stockholder buyout.  Rather, it was a stock-for-stock merger between Earthstone Energy, Inc. (“Earthstone”) and Bold Energy III LLC (“Bold”), both of which were controlled by EnCap Investments L.P. (“Encap”), which was alleged to have actively participated in the conception and negotiation of the transaction.  Noting that the “same principles” articulated in MFW and Synutra “apply whether the controller is directly or indirectly exerting its influence over the transaction,” the Court applied the MFW/Synutra framework to the Earthstone minority stockholders’ post-closing damages claims challenging the transaction.

The Court of Chancery had dismissed plaintiffs’ claims, applying business judgment review under MFW  after finding that only preliminary and “exploratory” discussions occurred before MFW’s dual protections were put in place.  The Delaware Supreme Court, however, held that the complaint’s well-pled facts “support[ed] a reasonable inference” that the MFW protections were not put in place early enough in the transaction process and reversed.

As a preliminary matter, the Supreme Court agreed with the Court of Chancery that “preliminary discussions between a controller’s representatives and representatives of the controlled company do not pass the point of no return for invoking MFW’s protections,” and that “some of the early interactions between Earthstone and EnCap” in this case “could be fairly described as [such] preliminary discussions.”  The Court, however, found that the “well-pled facts in the complaint support 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.”  In particular, the Court pointed to “multiple substantive economic communications between Earthstone and EnCap” in the months before Earthstone conditioned its offer on the dual protections:

  • Approximately three months before the Earthstone Special Committee was formed and the dual protections were put in place, Earthstone management delivered a presentation to EnCap about the proposed deal indicating an equity valuation for Bold of approximately $305 million.
  • About a week later, Earthstone management made another presentation to EnCap about the transaction, this time raising its indicative valuation to approximately $335 million.
  • Several days after the second presentation, Earthstone gave EnCap’s investment banker access to a data room that included Earthstone’s valuation model for a combination of Earthstone and Bold as well as a model of Earthstone’s net asset valuation.
  • Earthstone, EnCap and Bold then engaged in numerous meetings and “meaningful on-site due diligence” regarding Bold.[3]

The Court held that “[b]ased on these facts, it is reasonable to infer that these valuations set the field of play for the economic negotiations to come,” an inference that was further supported by the fact that, as alleged in the complaint, the offers that were subsequently made and ultimately accepted by Earthstone’s Special Committee after the dual protections were put in place were close to the “indicative valuations” Earthstone management had presented to EnCap several months earlier.  For that reason, the Court held that the complaint adequately pled that the parties had effectively engaged in “substantive economic negotiations” before the dual protections were in place, and thus the complaint “should not have been dismissed on MFW grounds.”

Although the application of MFW’s timing requirement will depend on the facts of each case, this decision, together with Synutra, further clarifies where the line is between “preliminary discussions” – which are permissible before MFW’s dual protections are put in place – and “substantive economic discussions,” which are not.   Although a court may find initial, exploratory meetings or exchanges of information to be sufficiently “preliminary” not to preclude business judgment review, parties would be well-advised to avoid any discussions of valuation or other significant deal terms (even if not in the context of formal negotiations) until the controlling stockholder agrees to the dual protections and a special committee is formed and has retained appropriate advisors.

[1] See Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014).

[2] 195 A.3d 754 (Del. 2018).

[3] In addition to these factual allegations, the Court noted that Earthstone’s CEO had told the Earthstone Board that he was “negotiating” with Bold before the dual protections were put in place.