The Delaware Court of Chancery (the “Court”) recently ruled in Cigna Health and Life Ins. Co. v. Audax Health Solutions, Inc., C.A. No. 9405-VCP, 2014 WL 6784491 (Del. Ch. Nov. 26, 2014), that two fairly common devices used to impose obligations on stockholders in a private company merger were unenforceable under the facts and circumstances of the case. Specifically, the Court found unenforceable against the target’s stockholders who did not consent to the merger or otherwise sign deal documents (“non-signatory stockholders”), (i) a release of claims against the buyer where such release was contained in a letter of transmittal, but not in the merger agreement, and was unsupported by consideration separate from the merger consideration itself, and (ii) indemnification obligations in the merger agreement that were indefinite and that could equal the entirety of the consideration received in the merger. Although the holding in this case is narrow, and will likely be honed by future cases, it is an important reminder that buyers using a merger structure to acquire private companies must be careful in how they attempt to impose obligations upon non-signatory stockholders, as certain obligations may be held unenforceable.
The controversy arose from the acquisition (by merger) of Audax Health Solutions, Inc. (“Audax”) by Optum Services, Inc. (“Optum”), a part of the UnitedHealth Group family of companies (“United”). The merger was approved by a majority of the Audax board of directors and thereafter approved by 66.9% of the Audax stockholders via written consent under Section 251 of the Delaware General Corporation Law (“DGCL”). The Audax stockholders delivered their written consent to the merger in the form of a support agreement. In the support agreement, signatory stockholders not only consented to the merger, but also agreed (i) to release any claims against Optum (and Audax Holdings, Inc., a corporation formed by Optum as an acquisition vehicle, together, the “Optum Parties”) arising from the merger, (ii) to be bound by the terms of the merger agreement, including the indemnification obligations set forth therein, and (iii) to the appointment of Shareholder Representative Services, LLC as the stockholders’ representative.
In the merger agreement, some indemnification obligations survived for 18 months, some for 36 months, and some survived indefinitely. The merger agreement also required each non-consenting stockholder to deliver a letter of transmittal to the buyer in order to receive merger consideration for its shares. The letter of transmittal, consistent with the support agreements signed by the consenting stockholders, contained a release of claims against the Optum Parties.
Cigna Health and Life Insurance Co. (“Cigna”), a stockholder of Audax and a competitor of United, did not vote in favor of the merger, did not sign the support agreement, and refused to sign the letter of transmittal. As a result, Cigna did not receive merger consideration for its shares. Cigna sued and successfully obtained a judgment on the pleadings, wherein the Court found that (i) the release in the letter of transmittal was unenforceable because it was not supported by consideration, and (ii) the indemnification obligations in the merger agreement, some of which were capped only at the purchase price and indefinite in duration, violated Section 251(b)(5) of the DGCL (which requires the merger agreement to state a determinable consideration) in that all of the money received by stockholders could be subject to a clawback at any point in the future and, as such, the merger consideration was not actually determinable. Accordingly, Cigna was entitled to tender its shares of Audax stock and receive the merger consideration without accepting or being bound by the release of the Optum Parties or the indemnification obligations.
I. Court’s Analysis of the Release
The Court found the release of the Optum Parties in the letter of transmittal unenforceable because it was not supported by consideration separate from the merger consideration itself.
Section 251(b)(5) of the DGCL requires that a merger agreement state “the cash, property, rights or securities” that stockholders will receive in exchange for or upon conversion of their stock and surrender of any certificates evidencing them. Looking to its previous decision in Roam-Tel Partners v. AT&T Mobility Wireless Operations Holdings Inc., 2010 WL 5276991 (Del.Ch. Dec. 1, 2010), the Court found that the buyer’s obligation to pay merger consideration to stockholders was due and owing upon consummation of the merger and could not be subjected to further conditions post-closing without the payment of additional consideration.
The defendants argued that execution of the letter of transmittal was not an additional condition to receipt of merger consideration, but, rather, was required by the merger agreement itself, and was, therefore, part of the original consideration. To support this argument, the defendants attempted to construe the stockholders’ obligation to execute the letter of transmittal as a stated “right” among a “bundle of rights” under Section 251 (recall, Section 251 requires that the merger agreement state the “cash, property, rights or securities” to be paid). The Court disagreed with what it viewed as the defendants’ strained interpretation, finding that the term “rights” under Section 251 is meant to refer to benefits stockholders will receive in consideration for their shares, not obligations to which they will be subjected. The Court went on to note that the “sweeping” release language contained in the letter of transmittal was not contained in the merger agreement and that, if such a release obligation were construed as a “right” and part of the deal consideration that could be introduced after the merger agreement was signed, “buyers could impose almost any post-closing condition or obligation on a target company’s stockholders after the fact by including it in the letter of transmittal.”
In finding that the release was unenforceable because it was a new obligation for which no new consideration (separate from the merger consideration itself) was paid, the Court cautioned that parties who choose a Section 251 merger must follow the requirements of that section. In particular; if the buyer wanted to bind stockholders to the release obligation, it could have structured the transaction as a stock purchase in which it would have been in contractual privity with the stockholders (i.e., every stockholder would have been a direct signatory to the stock purchase agreement).
II. Court’s Analysis of the Indemnification Obligation
Unlike the release obligation, the purported indemnification obligations were contained in the merger agreement itself. The Court nonetheless found the indemnification obligations unenforceable as they were unlimited in duration and potentially implicated the entire merger consideration a stockholder would receive.
The defendants argued that the indemnification obligations were similar to an escrow agreement, widely held to be a permissible device, and that finding such indemnification obligations unenforceable would endanger the long-accepted escrow mechanism. The Court disagreed, finding that due to its lack of temporal or monetary limitation, the indemnification claw-back was not like a traditional escrow, but, rather, amounted to a 100% indefinite escrow. The Court found such a structure not only unusual, but also in violation of DGCL Section 251(b)(5), which requires that the merger agreement clearly state the consideration to be paid. The Court noted that the obligations were more akin to an open-ended post-closing price adjustment.
In determining that validity of post-closing price adjustments, the Court further explored the language of DGCL Section 251(b), which provides that: “[a]ny of the terms of the merger agreement 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 Court looked to its previous decision in Aveta v. Callieri, 23 A.3d 157 (Del. Ch. Sep. 10, 2010), in which it found a post-closing purchase price adjustment was permissible under DGCL Section 251 when it was based on financial figures from the target’s financial statements, the formulas for which were clearly and expressly set forth in the purchase agreement. The Court found the indemnification obligations at issue were unlike Aveta because they were not tied to financial statements or other measures that would clearly set forth the means for determining merger consideration, but, rather, were based on any damages the Optum Parties might suffer, placed all of the merger consideration at risk, and continued indefinitely.
Interestingly, the Court determined that while the indemnification obligations may technically have satisfied the “facts ascertainable” test, the uncertainty of the provision operated to cause the merger consideration itself to be unascertainable, thereby violating DGCL Section 251(b)(5), which requires that the merger agreement clearly state the consideration to be paid. As Cigna could never know the exact value of its merger consideration, the indemnification obligations, albeit contained in the merger agreement, were not enforceable against non-signatory stockholders and could not be used as a condition for the release of Cigna’s merger consideration. The court noted that individual stockholders could contract for such open-ended indemnification obligations, but they could not be “foisted on non-consenting stockholders.”
It is important to note the limitation expressly included by the Court in this decision. The Court’s ruling only relates to indemnification obligations with both unlimited time and exposure up to the purchase price. The Court expressly stated that it was not ruling on the validity of a price adjustment that is limited by either duration or amount, but was only ruling on a price adjustment that lacked both limitations.
III. Court’s Analysis of Appointment of Stockholder Representative
Cigna also argued that the appointment of Shareholder Representative Services, LLC, as stockholders’ representative (required by the merger agreement), deprived it of the ability to defend against indemnification claims and was unenforceable. The Court in Cigna did not make a finding on this matter, as it ultimately determined that Cigna did not brief the issue sufficiently to support a motion for judgment on the pleadings.
However, the Aveta Court, cited in Cigna, did rule on facts very similar to those in Cigna. In Aveta, non-signatory stockholders objected to a purchase price adjustment made by a stockholders’ representative, Roberto L. Bengoa (“Bengoa”), whose appointment was required by the purchase agreement, and who was authorized to negotiate the purchase price adjustment with the buyer on behalf of the target’s shareholders. Certain non-signatory shareholders revoked the designation of Bengoa as shareholders’ representative, claiming he had no authority to represent them.
The Court found that the appointment of Bengoa was valid and his actions in determining the purchase price adjustment were binding upon non-signatory stockholders under DGCL Section 251 (although decided under Puerto Rican law, the relevant provision, Section 3051(b) of the General Corporation Law of 1995 of the Commonwealth of Puerto Rico, mirrored the language of DGCL 251). As noted above, Section 251 provides that the terms of the merger agreement may be made dependent on facts ascertainable outside of the purchase agreement. The Court concluded that under Section 251, “facts” include “determinations and actions of a designated person or body.” This definition of “facts” encompassed the appointment of Bengoa and the undertaking of his actions with respect to the purchase-price adjustment pursuant to the mechanics prescribed by the purchase agreement.
While a question remains as to how the Cigna Court would interpret the required appointment of the shareholders’ representative given that, as stated by the Court, “[t]he propriety of stockholder representatives under the DGCL is the subject of active and ongoing debate,” under Aveta, it appears likely that the Court would find the appointment binding upon Cigna.
In light of Cigna, it is evident that the most direct way to ensure that stockholders will be bound by obligations of release and indemnification is to have them sign the deal agreement directly. This can be accomplished in the form of joinders to a merger agreement or a stock purchase agreement. But where there are numerous stockholders or a stock purchase structure is otherwise not practical, the buyer should consider the following:
- Avoid attempting to impose obligations on target-company stockholders through letters of transmittal, as obligations contained therein may be held unenforceable.
- Although the Court in Cigna was not faced with a challenge of the indemnification or release obligations by a stockholder who had consented to the transaction, given that the court limited its finding to apply to “non-consenting stockholders,” if relevant stockholder obligation provisions were contained in the merger agreement, and sufficient disclosure was provided regarding such obligations, it seems plausible that the Court might enforce such obligations with respect to a “consenting stockholder.” Accordingly, buyers should include all such obligations in the merger agreement itself, provide adequate disclosure of the same in the consent solicitation or proxy materials distributed to stockholders, and attempt to ensure approval by as many stockholders as possible through signing the agreement itself.
- Provide additional consideration for a release by stockholders, potentially in the form of cash or a release of the stockholder.
- If it is important to impose certain obligations on key stockholders, condition the closing on such stockholders’ acceptance of the desired obligations (though sophisticated stockholders may leverage the “holdup value” to the transaction that this otherwise provides them).
- Secure indemnification obligations by holding back or placing in escrow a portion of the purchase price, rather than attempting to claw-back consideration already paid.
- Whether an escrow or an indemnification claw-back, and even when such provisions are included in the merger agreement itself, impose appropriate caps and time limits on the obligation so that it is ascertainable and therefore more likely to be enforced. Also, buyers should consider representations and warranties insurance to take the place of an open-ended stockholder indemnification obligation.
Also note that there may be other ways to bind stockholders to obligations like the ones sought in Cigna. For instance, if target stockholders are party to a stockholders agreement that contains a drag-along provision, such provision may include the ability to force the (signatory) stockholders to agree to provide pro rata indemnification in a transaction up to the purchase price. Accordingly, any such existing agreements should be reviewed carefully in a given transaction, and, when drafting a stockholders agreement, the implications of Cigna should be carefully considered.