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Delaware Supreme Court Explains MFW’s Timing Requirement

When challenged, transactions involving a corporation and its conflicted controlling stockholder invoke Delaware’s rigorous form of judicial scrutiny, known as entire fairness review.  But not always.  With the right procedural protections in place, at the right time, even they can get the benefit of Delaware’s default deferential analysis, known as business judgment review.  Business judgment review usually equates to an early dismissal in litigation.

Under Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014), referred to as MFW, a conflicted controller transaction may get business judgment review when conditioned on two procedural protections.  Those involve approval by (i) an independent special committee and (ii) a majority of the minority stockholders.  To effectively neutralize the controller’s influence and avoid the safeguards becoming bargaining chips, MFW includes an important timing requirement.  MFW’s dual protections cannot be tacked on mid-negotiation; they must be imposed “ab initio,” i.e., “from the beginning.”

Recently, in Flood v. Synutra, 195 A.3d 754 (2018), the Delaware Supreme Court explained what from the beginning is.  There, the Court declined to adopt a bright-line test, holding that the dual MFW protections need not be part of the first expression of interest.  Rather, under Synutra, it is enough that they are in place early and before substantive economic negotiations occur.  Applied in that case, the rule permitted business judgment review in circumstances where the controller agreed to the MFW protections shortly after its initial expression of interest but before substantive economic negotiations.

The recent decision in Olenick v. Lodzinksi, No. 392, 2018 (Del. Apr. 5, 2019) represents the latest word from the Delaware Supreme Court on MFW’s timing requirement.  We previously summarized Olenick on the blog (available here).  This entry includes a more robust discussion of this important decision.

The Court of Chancery’s Dismissal in Olenick Applying MFW

The claims in Olenick challenged a business combination between two companies in the oil and gas sector, Earthstone and Bold.  Each was controlled by the same private equity firm, EnCap.  Interest in the Earthstone-Bold transaction began in fall 2015, sparked by Earthstone’s CEO, an individual affiliated with EnCap, who led the early discussions.  Over the course of three months, the parties entered into confidentiality agreements, shared Bold’s financial information, and involved Bold’s financial advisor and technical employees.  Earthstone also met with financial advisors to solicit their views. 

Discussions stalled in light of market conditions but heated up again in spring 2016.  Over another three-month period, EnCap shared Bold’s information with Earthstone, Earthstone provided valuations of Bold to EnCap, Earthstone shared its own financial information with EnCap and Bold, and party representatives met several times.  In July 2016, eight months into discussions, Earthstone formed a special committee to oversee the potential transaction.  In mid-August 2016, that committee sent a formal written proposal to Bold.  That proposal conditioned the transaction on the committee’s approval and, for the first time, imposed a majority-of-the-minority-vote condition.  By November 2016, the parties reached agreement on the transaction’s structure and final economic terms.  By spring 2017, Earthstone’s disinterested stockholders approved the deal. 

An Earthstone stockholder brought a direct and derivative action in Delaware challenging the transaction as unfair.  Defendants moved to dismiss, arguing that MFW applied given the special committee and majority-of-the-minority-vote conditions, invoking business judgment review and requiring a dismissal.  The Court of Chancery agreed with defendants and dismissed the case under MFW, finding MFW’s dual protections were established sufficiently early.  According to the trial court, the parties’ early interactions “never rose to the level of bargaining: they were entirely exploratory in nature.”  Notably, the trial court’s decision came before the Delaware Supreme Court ruled in Synutra.  

The Supreme Court Finds the MFW Protections Came Too Late

On appeal, the Delaware Supreme Court overturned that determination, finding the plaintiff’s complaint permitted a reasonable inference that the MFW protections were established too late to warrant business judgment review.  In doing so, the Court reaffirmed Synutra, explaining “[t]he Court of Chancery held correctly 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.” 

Here, however, several allegations gave rise to a reasonable inference that the MFW conditions came after the parties engaged in substantive economic discussions.  The Court cited statements by the Earthstone CEO implying negotiations began before Earthstone’s committee was established, as well as the eight-month period where the parties executed confidentiality agreements, exchanged financial information, involved financial advisors, provided valuations, and held numerous meetings. 

While some of the early discussions between Earthstone and EnCap were preliminary, the Court found that the complaint supported a pleading-stage inference that their talks became substantive economic discussions when the parties engaged in a joint exercise to value Earthstone and Bold.  That exercise, according to the Court, arguably “set the field of play for the economic negotiations to come by fixing the range in which offers and counteroffers might be made.”  Those discussions occurred before the parties adopted the MFW protections.  Thus, MFW was inapplicable and the transaction remained subject to entire fairness review.  The plaintiff’s complaint therefore was sufficient to survive a motion to dismiss, requiring a reversal.

Key Takeaway

Olenick reaffirms and illustrates the Synutra test for MFW’s timing requirement.  To gain the benefit of business judgment review for a conflicted controller transaction, MFW’s dual protections must be adopted early and before substantive economic negotiations occur.  Under Olenick, eight months in and after exchanging valuations probably is too late.