In a recent case, the Delaware Court of Chancery held that parties to a merger transaction could not require a minority stockholder to give the buyer a release that was not required as part of the merger agreement itself, or agree to indemnify the buyer indefinitely for post-closing indemnification obligations up to 100 percent of the merger consideration received. See Cigna Health & Life Ins. Co. v. Audax Health Solutions, Inc. 107 A.3d 1082 (Del. Ch. 2014). This decision has implications for any private business held by a diverse group of stockholders, and in particular for private equity funds, which typically hold a controlling interest along with other significant minority holders. In this case, Optum Services, Inc. (Acquirer), a Delaware corporation, entered into a merger agreement to acquire Audax Health Solutions, Inc. (Target), a Delaware corporation, through a newly-formed entity Audax Holdings, Inc. (Holdings), wholly-owned by Acquirer. Before the merger, Cigna Health and Life Insurance Company (Minority Holder) owned shares of Target’s Series B Preferred Stock.

Click here to view image.

The terms of the merger agreement conditioned receipt of the merger consideration on surrender of shares and execution of a Letter of Transmittal, which included (1) a release (Release) of any claims against Acquirer and Holdings, and (2) an agreement to be bound by the terms of the merger agreement, specifically including the provisions indemnifying Acquirer and Holdings for any breaches of Target’s representations and warranties (the Indemnification Obligation). Minority Holder refused to execute the Letter of Transmittal, and as a result Target, Acquirer, Holdings and SRS refused to pay Minority Holder its merger consideration of approximately $46 million.

The Court held that the Release was not enforceable for lack of consideration, specifically because it hadn’t been included within the merger agreement, and was only in the Letter of Transmittal (provided to stockholders after closing). Because the merger agreement did not indicate to stockholders that they might have to agree to a release, the release required separate consideration; without it, it was not enforceable.

Under the merger agreement, the Indemnification Obligation survived indefinitely and made the Minority Holder liable to Acquirer for up to 100 percent of the Minority Holder’s share of merger consideration. Minority Holder argued that this violated Section 251 of the Delaware General Corporation Law (DGCL) which requires that merger consideration be paid upon the consummation of the merger and cancellation of shares. Acquirer argued that the Indemnification Obligation was the economic equivalent of an escrow and also acted as a post-closing price adjustment, permissible under Section 251 of the DGCL. §251(b) states: Any of the terms of the agreement of merger or consolidation may be made dependent upon facts ascertainable outside of such agreement, provided that the manner in which such facts shall operate upon the terms of the agreement is clearly and expressly set forth in the agreement of merger or consolidation. The term “facts,” as used in the preceding sentence includes, but is not limited to, the occurrence of any event, including a determination or action by any person or body, including the corporation.

The Court held that Indemnification Obligation violated Section 251(b)(5) of the Delaware General Corporation Law (DGCL) because it prevented the stockholders from determining the value of the merger consideration. Section 251 requires the merger agreement state “the cash, property, rights or securities of any other corporation or entity which the holders of . . . shares are to receive.” Here, the Court found that there was no point in time at which the merger consideration becomes firm or determinable, because the Indemnification Obligation continued indefinitely and put 100 percent of the merger consideration at risk.

To avoid a similar result in the future, business people and counsel should consider taking the following steps:

  1. Require stockholders to sign a Subscription Agreement or a Stockholder Agreement that obligates them to provide the same warranties and indemnification as the majority stockholder provides, and to indemnify a buyer in the event of a merger. Most Stockholder Agreements contain a drag-along provision which requires minority stockholders to sell their shares at the time a majority holder sells, or to vote in favor of an asset sale and provide the same warranties, covenant of indemnifications and agreements as the majority stockholder. However, many agreements fail to specifically require the same kind of covenants in the event of a merger, merely requiring the minority stockholder to vote in favor of a merger. The most opportune time to have an investor agree to be liable for a share of indemnification obligations in the event of a change of control is at the time the investor purchases its shares. Requiring this as part of a Subscription Agreement or Stockholder Agreement addresses the issue.
  2. Take the temperature of any significant minority stockholder prior to entering into a merger agreement and consider alternatives to a merger structure. If the attitude is hostile towards the agreement, consider switching the structure of the transaction to a stock purchase agreement or asset sale if there is a Stockholder Agreement or other written agreement covering indemnification obligations.
  3. Provide for a specific time limit or cap on indemnification obligations in the merger agreement. The Court in Cigna v. Audax specifically held that a stockholder must be able to ascertain the value of the merger consideration to be received at or about the time of the merger. The combination of the indefinite length of the indemnification with the risk of forfeiture of all of the merger consideration violated Section 251. If there had been a time limit or a cap on the total indemnification amount in Cigna v. Audax, the Court felt the stockholders would have been able to determine the value of their merger consideration as required by the DGCL and the indemnification obligation would have been upheld.
  4. Include any requirement for a release of claims against a party specifically within the terms of the merger agreement itself. The Court was troubled by the fact that the acquirer in Cigna v. Audax could “impose almost any post-closing condition or obligation on the target company’s stockholders after the fact by including it as a requirement in a letter of transmittal.” Cigna at 15. If the merger agreement had included the release, additional consideration wouldn’t have been necessary and the release would have been enforceable.