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Olenik v. Lodzinski

Supreme Court of Delaware

April 5, 2019

NICHOLAS OLENIK, Individually and on Behalf of All Others Similarly Situated, Plaintiff Below, Appellant,

          Submitted: February 6, 2019

          Court Below-Court of Chancery of the State of Delaware C.A. No. 2017-0414-JRS

         Upon appeal from the Court of Chancery of the State of Delaware: AFFIRMED IN PART, REVERSED IN PART, and REMANDED.

          Jeremy S. Friedman, Esquire, Spencer Oster, Esquire, and David F.E. Tejtel, Esquire, Friedman Oster & Tejtel, PLLC, New York, New York; Ned Weinburger, Esquire (argued), and Thomas Curry, Esquire, Labaton Sucharow LLP, Wilmington, Delaware; Peter B. Andrews, Esquire, Craig J. Springer, Esquire, and David Sborz, Esquire, Andrews & Springer LCC, Wilmington, Delaware, for Appellant, Nicholas Olenik.

          Kenneth J. Nachbar, Esquire (argued), D. McKinley Measley, Esquire, and Lauren Neal Bennett, Esquire, Morris, Nichols, Arsht & Tunnell LLP, Wilmington, Delaware; Gerard G. Pecht, Esquire, Norton Rose Fulbright U.S. LLP, Houston, Texas; Peter A. Stokes, Esquire, and William Patrick Courtney, Esquire, Norton Rose Fulbright U.S. LLP, Austin, Texas, for Appellees Frank A. Lodzinski, Ray Singleton, Bold Energy III LLC, and Earthstone Energy, Inc.

          Rolin P. Bissell, Esquire, and James M. Yoch, Jr., Esquire, Young Conaway Stargatt & Taylor, LLP, Wilmington, Delaware; Michael C. Holmes, Esquire, Craig E. Zieminski, Esquire, Stephen S. Gilstrap, R. Kent Piacenti, Esquire, and Jeffrey Crough, Esquire, Vinson & Elkins LLP, Dallas, Texas for Appellees Douglas E. Swanson, Brad Thielemann, Robert L. Zorich, EnCap Investments L.P., Bold Energy Holdings, LLC, and Oak Valley Resources, LLC.

          Before STRINE, Chief Justice; VALIHURA, and SEITZ, Justices.

          SEITZ, JUSTICE

         Nicholas Olenik, a stockholder of nominal defendant Earthstone Energy, Inc., brought class and derivative claims against the defendants challenging a business combination between Earthstone and Bold Energy III LLC. As alleged in the complaint, EnCap Investments L.P. controlled Earthstone and Bold and caused Earthstone stockholders to approve an unfair transaction based on a misleading proxy statement. The defendants moved to dismiss the complaint on several grounds. They claimed that the proxy statement disclosed fully and fairly all material facts about the transaction, and Earthstone conditioned its offer on the approval of a special committee and the vote of a majority of the minority stockholders. Thus, under Kahn v. M&F Worldwide Corp., [1] instead of the exacting entire fairness standard of review, business judgment review should apply leading to dismissal.

         The Court of Chancery agreed with the defendants and dismissed the case. Two grounds were central to the court's ruling. First, the proxy statement informed the stockholders of all material facts about the transaction. And second, although the court recognized that EnCap, Earthstone, and Bold worked on the transaction for months before the Earthstone special committee extended an offer with the so-called MFW conditions, it found those lengthy interactions "never rose to the level of bargaining: they were entirely exploratory in nature."[2] Thus, in the court's view, the MFW protections applied, and the transaction was subject to business judgment review resulting in dismissal.

         While the parties briefed this appeal, we decided Flood v. Synutra International, Inc.[3] Under Synutra, to invoke the MFW protections in a controller-led transaction, the controller must "self-disable before the start of substantive economic negotiations."[4] The controller and the board's special committee must also "bargain under the pressures exerted on both of them by these protections."[5]We cautioned that the MFW protections will not result in dismissal when the "plaintiff has pled facts that support a reasonable inference that the two procedural protections were not put in place early and before substantive economic negotiations took place."[6]

         The Court of Chancery held correctly that the plaintiff failed to state a disclosure claim. But, the complaint should not have been dismissed in its entirety. Applying Synutra and its guidance on the MFW timing issue-which the Court of Chancery did not have the benefit of at the time of its decision-the plaintiff has pled facts supporting a reasonable inference that EnCap, Earthstone, and Bold engaged in substantive economic negotiations before the Earthstone special committee put in place the MFW conditions. We also find no merit to the defendants' alternative ground for affirmance based on EnCap's supposed lack of control of Earthstone. The Court of Chancery's decision is affirmed in part and reversed in part, and the case remanded for further proceedings consistent with this opinion.



         According to the allegations of the complaint, which we accept as true at this stage of the proceedings, nominal defendant Earthstone is an upstream oil and gas company developing domestic oil and gas reserves. EnCap is a Delaware limited partnership operating as a private equity and venture capital firm focusing on domestic oil and gas ventures. EnCap had two holdings relevant to this appeal- Oak Valley Resources, LLC, a Delaware limited liability company, which in turn owned a controlling stake in Earthstone; and Bold, a Texas limited liability company controlled by EnCap with substantial undeveloped oil and gas resources in Texas and New Mexico.

         Frank Lodzinski founded Oak Valley in 2012, and served as its president and chief executive officer. Lodzinski and EnCap have a history of successful investments in the oil and gas industry. EnCap came to control Oak Valley through a reverse merger when EnCap contributed membership interests in three subsidiaries in exchange for a controlling interest in Earthstone. Lodzinski and three other members affiliated with EnCap made up four of the five Oak Valley board of managers. Affiliates of EnCap had the contractual right to nominate a majority of the Oak Valley board of managers.

         From December 2014 through June 2016, EnCap owned more than 50% of Earthstone through its majority membership interest in Oak Valley. After a 2016 reverse merger involving Earthstone and Oak Valley, Oak Valley's ownership interest in Earthstone dropped to 41%. The following chart shows Earthstone's corporate structure post-2016 reverse merger:

         (Image Omitted)

         After investing in December 2014, EnCap installed new Earthstone management, with Lodzinski as president and chief executive officer. Earthstone also employed several individuals who work for an Oak Valley affiliate. At this point, EnCap and certain of its affiliates "through their direct and indirect ownership may be deemed to share the right to direct the disposition of the Common Stock held by Oak Valley through the EnCap Oak Valley Funds' interest in Oak Valley and EnCap Fund IX's ownership of Bold."[7] In its 10-K report following the 2016 reverse merger, Earthstone stated that it remained a controlled company:

So long as OVR [Oak Valley] continues to control a significant amount of our common stock, OVR will continue to be able to strongly influence all matters requiring stockholder approval, regardless of whether or not other stockholders believe that a potential transaction is in their own best interests. In any of these matters, the interests of OVR may differ or conflict with the interests of our other stockholders. Moreover, this concentration of stock ownership may also adversely affect the trading price of our common stock to the extent investors perceive a disadvantage in owning stock of a company with a controlling stockholder. As of March 1, 2017, OVR controls 9, 162, 452 shares of our common stock, or 41.1% of the outstanding shares.[8]


         Turning to the transaction at issue in this appeal, the Earthstone-Bold business combination has its roots in mid-2015 when EnCap began looking for ways to sell Bold or take it public. The plaintiff's theory is that Bold required large capital commitments from EnCap's investment funds to sustain its oil and gas operations. In the summer of 2015, EnCap reached the end of its capital commitments, was hesitant to invest more capital into Bold, and saw problems taking Bold public.[9] EnCap retained an investment banker "to determine whether there was a market for Bold's assets."[10] The banker came up dry due to falling oil and gas prices. According to the plaintiff, EnCap had run out of options to meet Bold's heavy capital requirements and keep Bold afloat. Even with the final capital call from EnCap, "Bold d[id] not have enough cash and drilling capacity to continue to run the company . . . ."[11]

         Meanwhile, Earthstone in 2014-15 was pursuing a number of acquisitions, which led to its interest in an Earthstone/Bold transaction. In the fall of 2015 Lodzinski saw an opportunity to combine Earthstone's cash-generating assets with Bold's undeveloped resources. He initiated discussions with EnCap about a possible Earthstone-Bold transaction which, according to the plaintiff, was done without informing the Earthstone board. Those early interactions included:

• 11/2015 - EnCap provided Lodzinski and Earthstone management with Bold's marketing pitchbook followed by a conference call with EnCap to discuss a business combination. Earthstone and EnCap entered into a confidentiality agreement covering Bold's internal information. Bold shared financial information with Earthstone, which included access to Bold's data room set up from the earlier unsuccessful market survey.
• 11-12/2015 - Earthstone contacted Bold's investment banker and Earthstone's and Bold's technical employees met with a consultant to discuss Bold's assets. Earthstone and Bold entered into another confidentiality agreement covering Bold technical, operational, financial, and analytical information prepared by Bold and its investment banker, followed by a banker presentation presenting a technical overview of Bold's assets to EnCap and Earthstone, and a follow up meeting among the same parties.
• 12/15-1/16 - Lodzinski and Earthstone management met with investment banking firms "to solicit their views on valuation parameters related to Bold's assets, methods to fund their development, and equity market receptivity to potential acquisition of Bold's assets."[12]


         Earthstone and EnCap put their discussions on hold in early 2016 when oil prices reached a twelve-year low. But, in April 2016, Lodzinski rekindled his interest in Bold and provided Earthstone's board with a letter discussing Earthstone's operations. In that April 27 letter, Lodzinski described a transaction with Bold as a "Current Deal[]," noted he was "updating analysis," and also wrote "intend to make offer."[13] For the next few months Lodzinski led substantive financial discussions among EnCap, Earthstone, and Bold about a transaction:

• 05/02/2016 - EnCap provided Earthstone more information on Bold's projects and "indicated it would begin to build an independent evaluation model of Earthstone and Bold" to use "in evaluating any potential business combination."[14]
• 05/11/2016 - Without assistance from an independent financial advisor, Earthstone delivered a presentation to EnCap proposing an equity valuation for Bold of approximately $305 million in Earthstone common stock.[15]
• 05/18/2016 - Earthstone revised their proposed valuation to $335 million after EnCap apparently made no response.[16]
• 05/23/2016 - Earthstone granted EnCap access to its corporate data room which included a combined corporate model of Earthstone and Bold and an Earthstone net asset value model.[17] Bold got access a month later.
• 06/03/2016 - Earthstone and Bold officers discussed "a suggested action plan to be carried out during the ensuing weeks and months, relating to a possible transaction."[18]
• 06/27/2016 - Earthstone and Bold management met to go over Bold's assets and visited some Bold operations.[19]
• 07/06/2016 - Earthstone, EnCap, and EnCap counsel met "to develop a preliminary timeline to complete a possible transaction, identify the participants and their counsel, and assign responsibilities to complete the proposed transaction."[20]


         On July 8, 2016-over two months after Earthstone and EnCap restarted discussions about a potential deal and almost eight months after the initial discussions between Lodzinski and EnCap-Earthstone's two independent directors, Joliat and Urban, held a conference call with Earthstone management and Earthstone's legal counsel. Joliat and Urban said they would form a special committee to oversee the potential transaction.

         While the board was in the process of forming the special committee, substantive discussions continued over the transaction. On July 12, 2016, Lodzinski met with Bold's chief financial officer and executive vice president for business development to discuss, among other things, employee matters and the future composition of the combined board.[21] On July 19, 2016, Earthstone employees met with Bold representatives and toured some Bold facilities.[22] And, on July 22, 2016, Lodzinski and Anderson made a presentation to the unofficial special committee members about the status and plan for the transaction, including information about what Earthstone would do with Bold's assets, an updated valuation of Bold reflecting a value between $300 and $350 million, possibly structuring the deal using an initially tax-free "Up-C" structure, and a possible tax receivable agreement that would benefit EnCap that Earthstone was working on with EnCap's outside counsel.[23] Operational and technical employees of the two companies also continued to meet and visit Bold's drilling locations in West Texas.[24]

         On July 29, 2016, the Earthstone board formally established the special committee consisting of Joliat and Urban. According to the proxy statement, the special committee's charter gave the committee the power to:

(i) "determine whether or not to make a formal offer of combination with Bold and if so, the terms and conditions of such offer;
(ii) negotiate and oversee the documentation of any such offer;
(iii) retain its own financial advisor and legal counsel;
(iv) solicit the views of, and obtain information from, Earthstone's executive, financial and other officers; and
(v) reject the potential transaction, cease further negotiations and 'walk away.'"[25]

         The charter also provided that the Earthstone board would not approve a transaction without the special committee's favorable recommendation.[26] There was not, however, a condition that any transaction be approved by a majority-of-the-minority stockholder vote. About the same time, the special committee selected Stephens Inc. as its financial advisor.

         On August 10, 2016, the full board held a regularly scheduled meeting to discuss the transaction. According to management-prepared discussion materials, the plan was to "Announce Project Boldstone" in the third or fourth quarter.[27]During the meeting, "the directors discussed the potential Bold transaction and its pro forma financial and operational impact on Earthstone."[28] Like the board's previous meeting in May, the board held the meeting at EnCap's offices and was attended by the same two EnCap employees who attended the previous meeting. "All directors were supportive of a transaction between Earthstone and Bold and directed the proper officers to continue to pursue such a transaction."[29]

         On August 16, 2016, the special committee met with its counsel and Stephens to receive Stephens's preliminary financial analysis and discuss the terms of an offer to Bold. Although the minutes of the meeting state that "the deal currently being contemplated by [Earthstone] includes an equity split of 60% for Bold and 40% for [Earthstone]," Stephens's "contribution analysis show[ed] that the average contribution is 37.2% for Bold and 62.8% for [Earthstone]."[30] The Stephens representative stated that "the Committee should be aware that the contribution analysis does not support the currently proposed split between [Earthstone] and Bold."[31] He also noted that Earthstone's projections were based on a 10% discount to the stock price and that he was "not sure why such a discount would be used in this case."[32]

         Later that same day, the special committee met with Earthstone management to continue discussions about the transaction. The committee discussed, "among other matters, the proposed transaction, recent transactions in the Midland Basin, competition, management's current views on valuation and contribution analysis, the sources of the information provided to Stephens, anticipated market impacts on Earthstone and submission of a proposal to Bold."[33]

         On August 19, 2016, the special committee met again about the transaction. According to the minutes, the committee "determined that the price of the Company's stock in the transaction should not be calculated at a discount, the weighted average trading price for the 30 days prior to signing should be used to determine the Company's stock price," and "the transaction should result in the Company [Earthstone] owning more than 40% of the resulting entity," with a $325 million purchase price based on Bold's enterprise value.[34] The minutes further suggest that the special committee reduced the amount Earthstone would own in the resulting entity from Stephens's earlier analysis because that earlier analysis did not estimate Bold's cash flows far enough into the future. In other words, Bold was an early-stage company with long-term potential but uncertain short-term prospects. The committee then authorized Lodzinski to send an offer letter to Bold.


         Lodzinski sent a formal written proposal to Bold's President, Castillo (the "August 19 Letter"). Consistent with the special committee's instructions, the August 19 Letter proposed to acquire all of Bold's assets and liabilities through "a private stock transaction with a face value of $325 million funded through the issuance of shares of Earthstone's common stock," less net financial obligations not to exceed $25 million.[35] According to the proxy statement, assuming an equity valuation of $300 million for Bold and $10.50 per share for Earthstone stock, "the offer would have resulted in Bold owning about 55% of the combined entity on a fully diluted basis."[36] The August 19 Letter also conditioned the transaction on approval by the special committee and, apparently for the first time, "Earthstone's stockholders, including the holders of a majority of the common stock held by persons other than EnCap Investments LP and its affiliates and associates."[37]

         Five days after the special committee sent the August 19 Letter, Lodzinski met with Castillo to discuss Earthstone's offer and "begin more detailed negotiations on the broader terms of the proposed transaction."[38] A week later, Castillo formally responded to Earthstone's proposal. ...

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