In its recent decision in The Williams Cos., Inc. v. Energy Transfer Equity, L.P., et al.,1 the Delaware Supreme Court offered guidance on the interpretation of the “commercially reasonable efforts” standard in a merger agreement with respect to the delivery of a tax opinion under a closing condition.
Energy Transfer Equity L.P. (ETE) and The Williams Companies Inc. (Williams) are both midstream energy holding companies and substantial participants in the gas pipeline business. On September 28, 2015, ETE and Williams entered into a merger agreement pursuant to which Williams, through an intermediate holding company, would contribute its assets to ETE in return for $6.05 billion in cash along with equity in ETE. The parties intended that the contribution of the Williams asset to ETE should qualify as a tax-free transaction under Section 721 of the Internal Revenue Code and required, as a condition to closing, a legal opinion from Latham & Watkins LLP (ETE Tax Counsel), tax counsel to ETE, to that effect (the 721 Opinion). ETE agreed in the merger agreement to undertake commercially reasonable efforts to procure the 721 Opinion.
Following the execution of the merger agreement, oil prices declined and, as a result, the assets of Williams and ETE experienced a precipitous decrease in value. Williams was particularly affected by the downturn as one of its biggest customers, Chesapeake Energy, was rumored at the time to be seeking bankruptcy protection.
On March 29, 2016, ETE instructed ETE Tax Counsel to analyze whether it would be able to give the 721 Opinion. On April 11, 2016, ETE Tax Counsel informed ETE that it would not be able to provide the 721 Opinion and on the next day informed Cravath, Swain & Moore LLP (Cravath), Williams’ tax and deal counsel, of its conclusion. Cravath disagreed with ETE Tax Counsel’s conclusion but, on April 14, 2016, offered two proposals to address ETE Tax Counsel’s concerns. On April 18, 2016, four days after Cravath sent its alternative proposals to ETE Tax Counsel, ETE went public with the information that ETE Tax Counsel would not be able to deliver a 721 Opinion. On April 29, 2016, 15 days after Cravath sent its alternative proposals, ETE Tax Counsel communicated to Cravath that it had reviewed the alternative proposals and determined that neither would give it the comfort needed to issue the 721 Opinion. On May 13, 2016, Williams filed a complaint in the Delaware Court of Chancery alleging that ETE breached the merger agreement by failing to use commercially reasonable efforts to obtain the 721 Opinion from ETE Tax Counsel.
During this process and over the course of the ensuing trial, a myriad of other law firms and experts were consulted on this issue, all reaching varying conclusions. Wachtell, Lipton, Rosen & Katz, ETE’s deal counsel, indicated that it would be prepared to issue the 721 Opinion. Gibson Dunn & Crutcher LLP, Williams’ other deal counsel, also reviewed the issue and determined that it could give a qualified 721 Opinion if asked but acknowledged that it would be difficult to reach such a conclusion. On the tax issue specifically, ETE consulted Morgan, Lewis & Bockius LLP, which concluded, on a different legal theory from that of ETE Tax Counsel, that it would not be able to give a 721 Opinion. ETE’s expert witness concluded that the transaction structure was flawed at inception and there is likelihood that it was never tax-free.
The Delaware Court of Chancery’s Decision
The Court of Chancery ruled in favor of ETE, holding, among other things, that commercially reasonable efforts impose a negative duty on ETE to not act unreasonably. Further, the Court of Chancery placed the burden on Williams to show that ETE had acted unreasonably and that such unreasonable act had a material effect on ETE Tax Counsel’s ability to issue the 721 Opinion. The court did not consider ETE’s request that ETE Tax Counsel reconsider its ability to deliver the 721 Opinion to be an unreasonable request and stated that even if it is an unreasonable request, it was not a material breach because ETE Tax Counsel reached its own conclusion on the issue independently of ETE’s request. Principal in the Court of Chancery’s analysis of this issue is the credence it granted to testimony by the lawyers at ETE Tax Counsel. The court concluded that, given ETE Tax Counsel’s reputation and national stature, ETE Tax Counsel would not be motivated to lie in order to appease ETE. Additionally, given the difference in opinions from the various law firms and experts on the tax structure, the court is persuaded that ETE Tax Counsel made a good faith determination that it could not issue the 721 Opinion.
In response to Williams’ argument that the burden should be on ETE to prove that its failure to take more forceful actions did not result in ETE Tax Counsel’s decision to not give the 721 Opinion, the Court of Chancery concluded in a footnote that even if the burden of proof was allocated to ETE, the result would be the same.
Williams appealed the decision to the Delaware Supreme Court, arguing, among other things, that the Court of Chancery erred in ruling that the “commercially reasonable efforts” standard imposes a negative duty as opposed to an affirmative duty, in placing the burden of proof on Williams, the non-breaching party, and in finding that any alleged breach of covenant by ETE did not materially contribute to ETE Tax Counsel’s decision to not give the 721 Opinion.
The Delaware Supreme Court Decision
With respect to the legal issues on appeal, the Delaware Supreme Court agreed with Williams that the “commercially reasonable efforts” standard imposes an affirmative duty to help ensure performance, as opposed to a negative duty not to thwart or obstruct performance, of the merger agreement. Therefore, ETE had an affirmative obligation to take all reasonable steps to obtain the 721 Opinion and a failure to take such reasonable steps would constitute a breach of such covenant. The court specifically identified the following courses of action as evidence of a breach of the obligation to use commercially reasonable efforts: the failure to direct counsel to engage earlier or more fully with opposing counsel, the failure to negotiate the issue directly with the counterparty, the failure to coordinate a response among the various parties, the publication of information detrimental to the achievement of the objective (in this case, ETE’s public announcement of ETE Tax Counsel’s decision not to issue the 721 Opinion before the issue was able to be fully vetted), and the failure to generally act like an enthusiastic partner in pursuit of consummation of the transaction. Further, to the extent that ETE had breached such covenant, the court held that the burden of proof would then be on ETE to show that the breach did not materially contribute to ETE Tax Counsel’s decision to not give the 721 Opinion. In accordance with the “clearly erroneous” standard of review with respect to questions of fact, the Delaware Supreme Court deferred to the Court of Chancery’s finding that, even if the burden of proof shifted to ETE, ETE’s breaches of the “commercially reasonable efforts” standard would not have materially contributed to ETE Tax Counsel’s decision to not give the 721 Opinion.
Chief Justice Strine dissented from the decision, arguing that the cursory treatment in a footnote is not a “substitute for proper analysis” and that a retrial is needed for ETE to prove that its breach did not materially contribute to the failure of ETE Tax Counsel to deliver the 721 Opinion. Central in the dissent’s analysis is whether ETE Tax Counsel would have come to a different conclusion on the 721 Opinion absent the “undue professional pressure.”
In the credit context, the “commercially reasonable efforts” standard is often imposed with respect to a borrower’s obligation to, among other things, (a) perfect certain collateral on the closing date (and, in some instances, obtain collateral documents such as landlord waivers), (b) repatriate sums held at foreign subsidiaries, (c) maintain credit ratings, (d) identify public versus nonpublic information, (e) comply with laws and (f) cause third parties to comply with certain negotiated objectives.
Following the Energy Transfer decision, in determining whether a performing party had complied with the obligation to use commercially reasonable efforts, parties and counsel should focus on whether the actions and conduct of the performing party conforms to that of an enthusiastic partner in pursuit of accomplishing the applicable objective.