When buying a private company controlled by a private equity sponsor but with a substantial number of other shareholders, a common technique to avoid the need to obtain signatures from all the shareholders to a stock purchase agreement is to effect the transaction by way of a merger, that once approved by the requisite shareholders, binds all shareholders to the transaction. The recent Delaware court decision in Cigna Health raises some challenges that practitioners will need to manage when using the merger structure. Since all shareholders would not be signing the merger agreement, it was also common to require a shareholder to submit a signed letter of transmittal as a condition to receiving its merger consideration, and to include in the letter of transmittal not only a representation regarding ownership of the stock being tendered, but also an agreement to be bound by various post-closing obligations, such as indemnity obligations, appointment of a shareholder representative to settle indemnity claims or post-closing purchase price adjustments, and a release of all claims against the transaction participants other than for the merger consideration. In some instances, we have even seen efforts to include non-compete and non-solicitation covenants in letters of transmittals.
The recent decision of the Delaware Court of Chancery, Cigna Health and Life Ins. Co. v. Audax Health Solutions, Inc.,1 has called into question the continued viability of this technique by holding that certain post-closing indemnity obligations and shareholder release provisions in the letter of transmittal were unenforceable against Cigna. However, the Court’s holding was narrowly tailored to the facts of the case, and while Cigna may have created more questions than it answers, through practical techniques and diligent planning, buyers can mitigate the effects of this decision.
In Cigna, the Court held two provisions of the intended merger structure unenforceable against a non-signatory shareholder of the acquired company; (a) a post-closing indemnity obligation to the extent that it put 100% of the merger consideration at risk of repayment to the acquiror for an indefinite period of time and (b) a broadly-worded shareholder release in a letter of transmittal that was sent to shareholders after the merger was consummated. Regarding the shareholder release, the Court determined that the shareholder is entitled by law to the merger consideration as a pre-existing duty that arises and vests upon the closing of a merger. Therefore, there was no additional consideration flowing to shareholders asked to sign a letter of transmittal in order to receive their pro rata portion of the merger consideration. Since the release was not supported by consideration, the Court ruled it unenforceable. The Court rejected the argument that the release was “part and parcel of the overall consideration” since the release was not even mentioned in the merger agreement.
The Court expressly limited its determination that the post-closing indemnity obligations were unenforceable in this instance because the combination of the uncapped indemnity and perpetual survival period placed a non-signatory shareholder’s entire merger consideration at risk for an indefinite period of time. The Court found that Section 251(b)(5) of the Delaware General Corporate Law requires stockholders be able to ascertain the value of the merger consideration either precisely or within a reasonable range of values, at or about the time of the merger. This allows dissenting shareholders to evaluate the merger and knowingly choose between accepting the merger consideration or exercising their appraisal rights. Since the indemnification survived indefinitely and could encompass all of the merger consideration, there was no point in time at which the merger consideration in this case could ever become firm or determinable, and thus, according to the Court, violated Section 251(b)(5) and was unenforceable. The Court distinguished the facts of this case from those in Aveta, Inc v. Cavallieri,2 which held that a post-closing price-adjustment was permissible under Section 251(b)(5), because in Aveta the adjustments were based on the company’s financial statements and did not place all the merger consideration at risk for an indefinite period of time. While the Cigna opinion lacked clear guidance on when provisions that put merger consideration at risk would be invalid, Vice Chancellor Parsons took pains to point out that the opinion was limited to the facts of the case and did not address the validity of indemnification obligations limited to amounts held in escrow, the general validity of post-closing price adjustments, or whether price adjustments that cover all of the merger consideration may be permissible if time-limited or whether non-time limited price adjustments as to some portion of the merger consideration would be valid.
Our view is that the decision on the indemnity obligation would have come out differently if the indemnity was subject to a reasonable cap and time period. Nevertheless, until Delaware courts provide further guidance, practitioners need to be mindful of the decision and to the extent possible structure around it or take steps to mitigate its impact. We offer below some techniques to consider:
- Secure support agreements and joinders from as many shareholders as possible prior to the closing and/or as a condition to the closing. The Court has made clear that even in the merger structure, “individual stockholders may contract–such as in the form of a Support Agreement–to accept the risk of having to reimburse the buyer over an indefinite period of time for breaches of the Merger Agreement’s representations and warranties.”
- Require shareholders that do approve the deal to be responsible for more than their pro rata share of indemnity obligations in the event some shareholders are non-signatory. This could be particularly useful with respect to “fundamental” representations, which are more likely to be uncapped and indefinite.
- Mandate control shareholders to exercise any available drag along rights before closing.
- Where possible, rely on an escrow/holdback of a portion of the merger consideration to satisfy representation and warranty indemnity obligations or a purchase price adjustment. Similarly, provide expressly for offset rights against post-closing payouts for deals that have earnouts and other forms of contingent consideration.
- Specify in the merger agreement that a portion of the merger consideration will be withheld as additional consideration for the acceptance and agreement to the terms of the letter of transmittal.
- Draft the merger agreement to include, with particularity, all contemplated post-closing target shareholder obligations and releases and state in the merger agreement that the purchase price is in consideration for and based on the expectation of enforceability of these obligations and that shareholders will be required to submit a letter of transmittal agreeing to these obligations as a condition to receiving the merger consideration.
- Describe in the merger agreement any post-closing indemnifications as obligations that give rise to clawback rights of the acquiror against the merger consideration and as integral factors of and limitations to the merger consideration.
- Agree upon temporal limitations for specific representations and warranties and limit the total exposure to an agreed upon percentage that is less than 100% of the total merger consideration to increase the likelihood of enforceability.
Secure representation and warranty insurance to mitigate the risk that the agreed upon remedies are deemed unenforceable.