(Article from Securities Law Alert, November 2014)
For more information, please visit the Securities Law Alert Resource Center.
In a decision dated October 24, 2014, the Delaware Chancery Court addressed “two different contested issues related to the law of controlling stockholders: (1) when is a stockholder a controlling stockholder?; and (2) which transactions involving a controlling stockholder implicate entire fairness?” In re: Crimson Exploration Inc. Stockholder Litig., 2014 WL 5449419 (Del. Ch. 2014) (Parsons, V.C.). The Chancery Court determined that a minority stockholder can only be considered a “controlling stockholder” if it “actually control[led] the board’s decisions about the challenged transaction.” The court further ruled that the controlling stockholder “must engage in a conflicted transaction” in order for entire fairness review to apply.
Background
Plaintiffs brought suit challenging the now-completed stock-for-stock merger of Crimson Exploration, Inc., and Contango Oil & Gas Company. Plaintiffs contended that Oaktree Capital Management, L.P., which held 33.7% of Crimson’s outstanding shares at the time of the merger, was a controlling stockholder of Crimson. Among other claims, plaintiffs asserted that Oaktree had breached its fiduciary duties to Crimson’s shareholders “by selling the company below market value for self-serving reasons.” Plaintiffs claimed that the Crimson-Contango merger must therefore be reviewed under the entire fairness standard.
Chancery Court Holds That a Minority Stockholder Is a Controlling Stockholder Only If It Actually Controlled the Board’s Decisions with Respect to the Challenged Transaction
The Chancery Court first addressed the question of when a stockholder may be deemed a controlling stockholder with fiduciary duty obligations to other stockholders of the corporation. The court noted that “Delaware law treats a majority stockholder as a controlling stockholder.” The Chancery Court conducted a review of cases in which “the parties disputed whether a non-majority stockholder satisfied this actual control test.” Based on these cases, the court found that “a large blockholder will not be considered a controlling stockholder unless [it] actually control[led] the board’s decisions about the challenged transaction.” The Chancery Court observed that there is no “linear, sliding-scale . . . whereby a larger share percentage makes it substantially more likely that the court will find the stockholder was a controlling stockholder.” Rather, courts have conducted “fact-intensive” assessments of “the actual control factor.” For example, in Kahn v. Lynch Commc’n Sys., Inc., 638 A.2d 1110 (Del. 1994), the Delaware Supreme Court found that a minority stockholder “who literally dominated the boardroom and threatened a hostile takeover” was a controlling stockholder. In the instant case, the Chancery Court observed that “[a]bsent a significant showing” of the minority stockholder’s “actual control” over the board, “courts have been reluctant to apply the label of controlling stockholder -- potentially triggering fiduciary duties -- to large, but minority, blockholders.”
Chancery Court Holds Entire Fairness Review Applies Only If the Controlling Stockholder Engaged in a Conflicted Transaction
The Chancery Court next considered the question of “[w]hich transactions involving a controlling stockholder trigger entire fairness review?” The court explained that “[e]ntire fairness is not triggered solely because a company has a controlling stockholder.” Rather, entire fairness applies only if the controller “engage[d] in a conflicted transaction.”
The Chancery Court found that courts have applied entire fairness review to two categories of transactions: “(a) transactions where the controller stands on both sides,” such “as when a controller buys out the minority,” and “(b) transactions where the controller competes with the common stockholders for consideration.”
The court explained that there are “three types of cases” that fall into the second category, in which the controlling stockholder “receives different consideration or derives some unique benefit from the transaction not shared with the common stockholders.” First, there are cases in which “the controller receives disparate consideration, which the board approves.” This “disparate consideration” sometimes includes “a separate class of high-vote stock” in exchange for the controller’s shares. Second, there are cases in which “the controller receives a continuing stake in the surviving entity, whereas the minority is cashed out.”
Finally, in the third subset of cases, “the controller receives a unique benefit” of some kind, “despite nominal pro rata treatment of all stockholders.” The court noted that “[t]he case law has recognized only a few situations” that fall into this category “where, despite the stockholders receiving the same consideration, the controller nonetheless receives a unique benefit and the court applies entire fairness.” Courts have found the entire fairness standard of review applicable in “unique benefit” cases where “(a) the controller eliminates something bad for it and good for the minority, … or (b) all parties suffer a sub-optimal sale price, but the controller still benefits because it receives cash to satisfy an idiosyncratic liquidity problem.”
Chancery Court Finds Entire Fairness Does Not Apply to the Crimson-Contango Merger
The Chancery Court then considered whether entire fairness review applied to the Crimson-Contango merger based on Oaktree’s alleged status as a “controlling stockholder.” The court emphasized that “the focus in a control analysis is on domination of the board with regard to the transaction at issue.” Here, the court found “no specific allegations from which a court reasonably could infer that Oaktree, alone or in combination with others, actually exercised control over Crimson or the negotiation of the [m]erger.”
The court further determined that plaintiffs had “failed to allege facts sufficient to support a reasonable inference that Oaktree was … conflicted in the Contango transaction, or that it received some benefit not shared with the common stockholders.” The court explained that here, “[e]very stockholder received the same exchange ratio.” All Oaktree received by way of an alleged “unique benefit” was a Registration Rights Agreement (“RRA”) that allowed Oaktree to sell its stock in the combined entity in a private placement. Because the RRA “appears to have had relatively minimal cash value to Oaktree … and no cash value to the minority[,]” the court found that the RRA was “not a sufficiently unique benefit to trigger entire fairness.” The court concluded that “none of [the] theories advanced by [p]laintiffs provide a basis for applying entire fairness review in this case.”
For more information please visit the Securities Law Alert Resource Center.