(Article from Securities Law Alert, January 2015)
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In a December 19, 2014 decision written by Chief Justice Strine in C&J Energy Services, Inc., et al. v. City of Miami General Employees’ & Sanitation Employees’ Retirement Trust, et al., 2014 WL 7243153 (Del. 2014), the Delaware Supreme Court reaffirmed that enhanced judicial scrutiny under Revlon requires that directors of a company make reasonable, but not necessarily perfect, decisions in pursuing a change-of-control transaction; that a passive, post-signing market check period may be sufficient to satisfy directors’ Revlon duties; and that “blue penciling” of an agreement by courts, to the detriment of the acquiror’s rights under the agreement, should be limited to instances where it is clear after trial (or based on undisputed facts) that there was misconduct by the acquiror, such as aiding-and-abetting a breach of a fiduciary duty.
Background
The case arose from the proposed merger, announced on July 25, 2014, between C&J Energy Services and a Bermuda-based division of Nabors Industries, a competitor of C&J. Among other benefits, the merger was expected to produce substantial tax savings from the re-domiciling of C&J from the U.S. to Bermuda, provided that Nabors owned a majority of the combined entity.
The transaction was structured as a merger of C&J with the Nabors subsidiary, with Nabors receiving shares in the merged entity (new C&J) representing approximately 53% of new C&J as well as approximately $938 million in cash. The existing C&J stockholders would own the remaining minority stake in new C&J. In order to mitigate the public stockholders’ loss of corporate control over new C&J, the board of C&J negotiated for several corporate governance related protections, including: (i) a bylaw providing that all of the new C&J stockholders would receive pro rata consideration in any sale of new C&J or its major assets, thereby allowing for an equitable sharing of any “future control premium” that Nabors might receive in a sale of its controlling stake in new C&J, (ii) the retention by C&J of management control of new C&J, and the right to nominate four directors, including the chairman, to the seven director board of new C&J, and (iii) a comprehensive, five-year “standstill” agreement from Nabors providing for, among other restrictions, a prohibition on the acquisition of additional shares and limitations on the sale of its new C&J shares to, for example, competitors and any person or group that would own more than 20% of new C&J. The merger agreement also contained a broad fiduciary-out provision that permitted the C&J board to terminate the proposed merger with Nabors if a more favorable deal emerged for the sale of C&J, a “modest” termination fee of 2.27% of the deal value, and a lengthy pre-closing period of approximately five months. The voting agreement that C&J’s CEO entered into in support of the merger would also terminate upon a decision by the C&J board to exercise its fiduciary out, leaving the CEO free to vote in favor of a competing deal.
In a bench ruling issued on November 24, 2014, the Court of Chancery, while admitting that its determination was a “very close call,” preliminarily enjoined for thirty days a vote by C&J stockholders on the merger, ordered C&J to solicit alternative transactions to the merger, and also provided that such solicitation and any subsequent negotiation by C&J of an alternative proposal would not constitute a breach of the merger agreement. The Court of Chancery based its decision and remedies on its determination of a “plausible” violation by C&J’s board of its duty of care under Revlon, citing the board’s failure to both affirmatively shop C&J and have an “impeccable knowledge” of the value of C&J.
Delaware Supreme Court Analysis
In reversing the judgment of the Court of Chancery, the Delaware Supreme Court assumed for purposes of its analysis that a change-of-control of C&J had occurred, thus invoking enhanced judicial scrutiny of the merger under Revlon. In its analysis, the Supreme Court reiterated that Revlon does not require a company to conduct an auction or to follow any specific process. The Supreme Court noted with approval Chancellor Allen’s reading of Revlon and its progeny to permit “a board to pursue the transaction it reasonably views as most valuable to stockholders, so long as the transaction is subject to an effective market check under circumstances in which any bidder interested in paying more has a reasonable opportunity to do so.” In its review of the factual record, the Supreme Court noted possible deficiencies in the C&J board sale process, including potential conflicts involving its primary financial advisor; limited direct board oversight and involvement in the merger negotiations; and “aggressive” compensation and severance packages offered by Nabors to the C&J CEO and other executives. On balance, however, the Supreme Court found that C&J’s majority-independent and generally well-informed board had met its Revlon duties by negotiating “a logical strategic transaction with undisputed business and tax advantages” to its shareholders, a merger agreement that contained a lengthy passive market check and only modest deal protections, and a host of bylaw protections that substantially mitigated the effects of the change-of-control of C&J, while also providing C&J’s “stockholders with a fully informed, uncoerced opportunity to vote to accept the deal.” The Court also noted that a private equity fund which owned 10% of C&J’s stock was supportive of the transaction, and that when a large stockholder receiving the same consideration as the other stockholders is supportive of a transaction, that is normally evidence of its fairness.
The Supreme Court rejected the Court of Chancery’s comments that Revlon “required impeccable knowledge” by the target’s board of the company’s value, noting that the C&J board was “well-informed” according to the Court of Chancery decision. The Supreme Court also emphasized several times that Revlon and similar decisions arose in situations in which a target board was resisting takeover bids from a higher bidder, whereas in this transaction there were no other bidders and the C&J stockholders had the right to vote down the proposed merger with Nabors if they so chose.
The Supreme Court also held that the Court of Chancery had misapplied the standard of review when granting a preliminary injunction enjoining the merger. The Court of Chancery erred when finding that the plaintiffs had shown “a plausible likelihood of success on the merits as to a breach of the duty of care” rather than requiring the plaintiffs to show “a reasonable probability of success on the merits.” Moreover, the Supreme Court suggested that an especially stringent examination of plaintiffs’ claims was warranted as “Delaware courts have emphasized that in cases like this … the showing of a reasonable probability of success must be ‘particularly strong’ when ‘no other bidder has emerged despite relatively mild deal protection devices’.”
The Supreme Court was also critical of the Court of Chancery for its issuance of a mandatory injunction requiring C&J to solicit alternative proposals in violation of the merger agreement while expressly providing that such a “go-shop” process would not constitute a breach of the merger agreement. In order to issue the unusual remedy of a mandatory injunction “the Court of Chancery must either hold a trial and make findings of fact or base an injunction solely on undisputed facts.” In this case, however, a number of important factual disputes remained unresolved and, accordingly, the Court of Chancery erred in issuing a mandatory injunction. Moreover, the Supreme Court emphasized that even “after a trial, a judicial decision holding a party to its contractual obligations while stripping it of bargained-for benefits should only be undertaken on the basis that the party ordered to perform was fairly required to do so, because it had, for example, aided and abetted a breach of fiduciary duty.” For these reasons, the Court of Chancery was not entitled to “blue-pencil” the merger agreement to “strip an innocent third party [Nabors] of its contractual rights while simultaneously binding that party to consummate the transaction.”
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