CHANCERY COURT FINDS TRANSACTION STRUCTURE CAN TRIGGER PRESUMPTIONS OF BUSINESS JUDGMENT DEFERENCE AT PLEADING STAGE
Nicholas Oleinik…v. Frank A. Lodzinski, et al., and Earthstone Energy,…
By: Carty Bibee and Samantha Beatty
In Olenik v. Lodzinski, C.A. No. 2017-0414-JRS (Del. Ch. July 20, 2018), the Court of Chancery, in a motion to dismiss, found that Earthstone Energy, Inc.’s (“Earthstone”) decision to employ the framework laid out in Kahn v. M&F Worldwide, Corp., 88 A.3d 635 (Del. 2014) (“MFW”) in structuring a transaction secured the benefit of the business judgment rule for its fiduciaries, even at the pleadings stage. The Court found that where the Plaintiff failed to plead waste, or facts which the Court could reasonably conceive as waste, the Plaintiff’s claim that officers and the controlling stockholder breached their fiduciary duties by approving an unfair transaction as interested parties, must be dismissed.
In June of 2015, Frank Lodzinski (“Lodzinski”), Chairman, President, and CEO of Earthstone, a company operating in the upstream oil and natural gas sector, began looking for acquisition targets. At the same time, EnCap Investments L.P., a private equity and venture capital firm (“EnCap”), was looking to take public Bold Energy III LLC, (“Bold”). EnCap held a 95.9% ownership in Bold. Lodzinski, a prominent figure in the oil and gas industry, also founded, and held a non-controlling interest in, Oak Valley, a holding company for upstream oil and gas companies (“Oak Valley”). By 2014, Oak Valley owned 84% of Earthstone’s common stock, while EnCap and its affiliates owned 57.3% of the membership interests in Oak Valley.
During November of 2015, Lodzinski initiated discussions with EnCap regarding Bold as a potential Earthstone acquisition target. Between November and July 2016, Lodzinski continued discussions with EnCap and Bold about the potential transaction. In July, 2016, Earthstone formed a special committee of independent directors, which retained its own legal counsel and a financial advisor. Earthstone eventually made a formal offer to Bold on August 19, 2016. After approval from both the special committee and 99.7% of Earthstone’s disinterested stockholders, on May 9, 2017, an all-stock “Up-C” business combination between Earthstone and Bold closed, whereby Earthstone’s stockholders came to own approximately 38.9% of the combined company.
Less than a month later, Plaintiff Nicholas Olenik (“Plaintiff”), an Earthstone stockholder, brought five direct and derivate claims challenging the transaction based on alleged fiduciary duty breaches. The complaint alleged that Lodzinski caused the Special Committee and the Board of Earthstone to approve the transaction for his own benefit and the benefit of EnCap and Oak Valley. Counts I through III alleged Earthstone directors, including Lodzinski, and EnCap and Oak Valley, as controlling stockholders, breached their fiduciary duties. Counts IV and V alleged Bold, EnCap and Oak Valley aided and abetted such breaches. On motion to dismiss, the Plaintiff argued that the standard of review should be entire fairness, in part because a controlling stockholder stood on both sides of the transaction. The Defendants in turn claimed that the transaction was structured with the MFW framework in mind precisely to gain the benefit of the business judgment review standard.
The Court found that Earthstone’s decision to employ the MFW framework, and its successful execution of the framework, made business judgment review the appropriate standard by which to evaluate the transaction, even at the pleadings stage. The Court confirmed the six elements that must be satisfied to earn business judgment review under MFW are as follows: (i) the controller must condition the procession of the transaction ab initio on the approval of both the special committee and a majority of the minority stockholders; (ii) the special committee must be independent; (iii) the special committee must be empowered to freely select its own advisors and to say no definitively; (iv) the special committee must meet its duty of care in negotiating a fair price; (v) the vote of the minority must be informed; and (vi) there can be no coercion of the minority.
Although the Plaintiff claimed (i) that the ab initio requirement was not satisfied because of Lodzinski’s initial communications with EnCap and Bold, (ii) that the special committee was not independent because it had ties to Oak Valley, EnCap, and Lodzinski, (iii) that the special committee allowed Lodzinski to control the negotiation and review process, and (iv) that the minority stockholder vote was not fully informed, the Court ultimately found that the Defendants executed the MFW standard sufficiently and found that the business judgment rule was applicable.
Arriving at this decision, the Court accepted as true the complaint’s well-pled factual allegations, drew all reasonable inferences in Plaintiff’s favor and reviewed each of the foregoing arguments in turn. First, the Court made clear that there is a difference between “discussions” about a potential deal and “negotiations.” Although Lodzinski had been in communications with EnCap and Bold, it was made clear that any transaction would be conditioned on the approval of both the special committee and a majority of the disinterested stockholders, before the first offer letter was sent. It was the first offer letter that was found to have started “negotiations,” making it irrelevant for purposes of MFW that Lodzinski had had conversations previously. The Court also found that plaintiffs attempting to establish a lack of independence must satisfy a materiality standard. The Court stated that financial ties, without more, are not disqualifying, but, suggested that plaintiffs must demonstrate that the director in question is either beholden to or subject to the interested party’s dominion to demonstrate a lack of independence. In fact, the Court found that the “telltale signs of a well-functioning special committee—independence, full and unfettered negotiating authority and careful deliberation—[were] all present here.” Additionally, the Court held that while stockholders must be informed, omitted immaterial facts do not have a bearing on stockholders’ ability to make an informed decision.
Because Earthstone utilized the MFW protective provisions, the Court held that business judgment was the operative standard of review, and because the transaction was not so extreme as to constitute waste, the Court gave deference to the judgment of the corporate fiduciaries. Based on this finding, the Plaintiff’s claims were dismissed.