Legal scholars have been debating the method by which contractual provisions should be interpreted in the Netherlands since 1981, when the Dutch Supreme Court rendered its landmark Haviltex decision on the interpretation of contracts. Even though numerous relevant Dutch court decisions on contract interpretation have followed, the debate remains quite alive.
Irrespective of the applicable law, it is imperative for investors – such as private equity parties – to be precise when drafting exit provisions in joint venture or shareholder agreements. Across the ocean in the U.S., this was demonstrated in the Oxbow Carbon & Minerals Holdings, Inc. V. Crestview-Oxbow Acquisition, LLC decision rendered by the Delaware Supreme Court on Jan. 17, 2019. The Delaware Supreme Court provided guidance for investors drafting such provisions, which guidance can also be of relevance in other jurisdictions.
A dispute arose as to whether two minority investors could force their co-investors to sell their equity interests (Units) by exercising their ‘Exit Sale Right’. The conditions for exercising this Exit Sale Right were laid down in the Limited Liability Company Agreement (Contract) entered into among all investors.
An Exit Sale was defined in the Contract as the “transfer of all, but not less than all of the then-outstanding Equity Securities of the Company and/or all of the assets of the company to any non-Affiliated Person(s) in a bona fide arms’-length transaction or series of related transactions (including by way of a purchase agreement, tender offer, merger or other business combination transaction or otherwise).” The Contract provided that the unidentified minority investors were entitled to drag the other investors in an Exit Sale.
The Exit Sale was, however, conditional, providing an investor could not be forced to sell its Units in the Exit Sale unless the investor received distributions equal to or higher than 1.5 times the investor’s initial capital contribution. This condition could not be fulfilled in relation to certain investors, each of whom obtained a minority equity interest in the company at a later time than the other investors and paid a higher price for their Units (the Small Holders).
As to the proper interpretation of the exit provision, the parties’ arguments could generally be categorized as follows:
- The Blocking Argument: If an Exit Sale does not satisfy the 1.5 times requirement for any investor and that investor chooses not to participate, then the Exit Sale cannot go forward, because it no longer would involve ‘all, but not less than all’ of the then-outstanding securities.
- The Leaving Behind Argument: If an Exit Sale does not satisfy the 1.5 times requirement for any investor, then that investor can choose to participate in the Exit Sale, but cannot be forced to sell, and the Exit Sale can proceed without such investor. The other investors which satisfy the requirement, however, can be forced to participate in the Exit Sale.
- The Top Off Argument: Assuming the ‘Blocking Argument’ were to be adopted and the Exit Sale would not satisfy the 1.5 times return on investment, the Exit Sale should still be able to proceed if the Small Holders (being the plaintiffs) were provided an additional amount of the sale proceeds such that they receive the 1.5 times return required by the Exit Sale provisions. This would effectively mean that the Small Holders would receive a higher purchase price than the other investors.
Dutch Legal Practice
The court in first instance found a gap in the Contract and used the implied covenant of good faith and fair dealing to imply a provision into the Contract which allowed the two minority investors to complete the Exit Sale if they came up with sufficient additional funds to satisfy the 1.5 times return for the Small Holders. The Delaware Supreme Court, on appeal, found that the court of first instance erred by finding that a gap existed in the Contract and implying a provision to fill such gap. Giving meaning to all of the provisions of the Contract, the Exit Sale provisions could only mean that an Exit Sale could not proceed where it does not satisfy the 1.5 times return for any of the investors and pay all of the investors the same consideration (which would result in paying all investors the amount necessary to satisfy the 1.5 times return for any investor). The Court found that the investors, being sophisticated parties, could have anticipated the impact that the admission of new investors would have on the Exit Sale, but did not elect to alter the Contract. The Court reiterated that the implied covenant of good faith and fair dealing should not be used as an equitable remedy to rebalance economic interests.
Dutch courts are in principle reluctant to fill any gaps by way of interpreting a contract (see Dutch Supreme Court, Dec. 9, 2016, ECLI:NL:HR:2016:2821, JOR 2017/55), even though the Dutch contract law doctrine of reasonableness and fairness could expand or limit the legal effects arising from a contract, which may lead to a similar result (see Clause 6:248, Dutch Civil Code ).
What the Delaware Supreme Court decision shows, irrespective of any debate on interpretation, is that clear drafting as well as identifying and addressing all potential contingencies remain vital, not only in private equity structures but in any contractual situation. This should be kept in mind in an era of ever-increasing deal speed and desire to reduce costs.
Lessons to be Learned
The Delaware Supreme Court decision highlights the need for parties drafting exit provisions in joint venture or shareholder agreements to address all potential contingencies, summarized as follows:
- If the exit provisions include a minimum return on investment requirement, the contract language should be clear on whether that minimum return on investment requirement creates a blocking right or a leaving behind right.
- Determine whether you want to have the flexibility of a topping off option or if the minimum return requirement may only be satisfied upon pro-rata and equal distribution of an exit sale’s proceeds.
- Be careful to address how any minimum return on investment requirement will apply to any potential future (minor or major) shareholders/investors.
- Be explicit regarding what type of exit sale (e.g., assets or equity) a member can force.
- Be explicit how a leaving behind concept would work in the event of a sale of all of the assets of the company.