Private Equity Law Review : New York Private Equity Lawyer & Attorney : Geoffrey Parnass : Corporate & Business Law

A July ruling by the Court of Chancery holds important lessons for how Delaware courts interpret advancement and indemnification provisions in limited partnership agreements. In J. Michael Stepp v. Heartland Industrial Partners, L.P., two former officers and directors of the defunct Collins & Aikman Corporation sought advancement of legal fees and indemnification from the company’s majority investor, Heartland Industrial Partners, L.P. After C&A disclosed historical accounting irregularities, J. Michael Stepp and David A. Stockman incurred hefty expenses resulting from civil and criminal proceedings brought against them in connection with their roles at the portfolio company. Heartland rebuffed the directors’ request, insisting that (i) the general partner of the private equity fund had the discretion to refuse their advancement application and (ii) the directors failed to satisfy the requirements of the partnership agreement’s indemnification clause. The Court of Chancery disagreed and chastised Heartland for relying on ambiguous contractual language to shirk its obligations.   

Contractual Ambiguity Resolved Against General Partner

In his opinion, Vice Chancellor Strine drew on general principles of Delaware contract law. Confronted with a partnership agreement marred by slipshod drafting, Strine emphasized the public policy considerations behind Delaware courts’ approach to interpreting the foundational documents of business entities. 

Delaware courts resolve ambiguities in governing instruments in order to provide uniform, predictable interpretations of the documents that officers, investors, and other constituencies who provide benefits to the entity rely on in making their decisions about whether to participate in the entity’s activities. This principle of interpretation protects the participants’ reasonable expectations, which in turn benefits the entity by encouraging participants to provide their capital, be it human or financial, at a lower cost than they would if they faced greater uncertainty.

Directors, officers, and employees of limited partnerships, Strine observed, generally do not take part in the negotiation of the partnership’s organizational documents. Consequently, when deciding whether to work for a limited partnership, they must rely on the plain meaning of the terms of the partnership agreement in order to understand their rights and obligations. To protect the reasonable expectations of people who join a partnership after its formation, Strine reasoned, Delaware courts construe ambiguous terms against the drafter of the governing instrument.     

Advancement of Legal Fees & Expenses

The court granted the directors’ motion for summary judgment that they had a mandatory right to the advancement of legal fees and expenses under the limited partnership agreement.   After finding themselves defendants in half a dozen civil actions, Stepp and Stockman first applied for advancement of legal fees and expenses to C&A’s and Heartland’s insurance carriers. Once they exhausted the insurance policies, the directors turned to Heartland itself. Heartland’s general partner refused to authorize their petition.  

The relevant section of the partnership agreement read: “[e]xpenses reasonably incurred by an Indemnitee shall be advanced by the Partnership,” but “[n]o advances shall be made by the Partnership. . . without the prior written approval of the General Partner.” Heartland claimed that the prior written approval requirement granted the general partner sole discretion to decide whether to accept or deny an application for advancement. The court rebuked Heartland for its strained interpretation of the written approval requirement because it eviscerated the mandatory advancement language. Strine instead construed the requirement as performing the ministerial function of ensuring the directors’ request for an advancement of expenses was reasonable. According to the court, the general partner did not have the power to withhold its written approval merely to block the directors’ contractual rights to mandatory advancement.

Indemnification of Legal Fees & Expenses

Stepp and Stockman sought indemnification for expenses related to their defense against criminal charges, all of which were dismissed without prejudice by a federal court. The partnership agreement contained expansive indemnification rights by promising the directors restitution for “any and all claims. . .of any nature whatsoever.” But the partnership agreement subjected this broad indemnity to certain qualifications. In its motion to dismiss, Heartland maintained that the partnership agreement required the directors to demonstrate good faith, lawfulness, and the absence of any willful or knowing misconduct. 

The partnership agreement was silent with respect to the rights of indemnitees who were successful in proceedings brought against them. As a result, the court held that the terms of the agreement did not clearly require an indemnitee to prove good faith, lawfulness, or lack of willful misconduct where, as occurred in the case of Stepp and Stockman, the indemnitee emerged victorious in the underlying proceeding. In support of its construction, the court cited recent Delaware case law mandating an award of indemnification after the dismissal of a case without prejudice. 

Indemnification decisions, the court explained, should be made on a case-by-case basis. Otherwise, directors who are defendants in lawsuits would have to wait until all proceedings against them have been dropped or resolved. To apply Heartland’s interpretation of the agreement would contravene Delaware’s “strong public policy interest in promoting indemnification. . . to encourage capable people to serve as directors.” Given the agreement’s mandatory indemnification provision and the directors’ successful defense against the criminal charges brought against them, the court observed that Heartland bore the burden of proof that Stepp and Stockman did not satisfy the indemnification requirements. The court accordingly rejected Heartland’s motion to dismiss the directors’ claims for reimbursement.

Freedom of Contract & Delaware’s Limited Partnership Act

Vice Chancellor Strine noted that Section 17-108 of Delaware’s Limited Partnership Act affords limited partnerships greater freedom to draft their own indemnification plans than is available to corporations under Section 145 of Delaware’s General Corporation Law. In the case of Heartland, the court remarked that “drafters of the Partnership Agreement used their contractual freedom to craft an approach to indemnification that employs language drawn from § 145, but in a selective way that creates some room for confusion.” 

When drafting indemnification provisions in limited partnership agreements, general partners should focus on clarity and not rely on boilerplate or statutory language adapted from other sources of law. Freedom of contract does not come without substantial responsibilities. Bespoke partnership agreements need to be tailored to the specific circumstances of the contracting parties and any potential third-party beneficiaries. Populating a limited partnership agreement with a farrago of provisos and exceptions does not give a general partner the right to break its explicit contractual promises.

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Attorneys for Biogen Idec Inc. and Elan Corporation finally faced off in a Manhattan federal court earlier this month. The two companies had adopted increasingly antagonistic postures towards one another as elements of Elan’s cooperation and financing agreements with a Johnson & Johnson subsidiary became public. Shane Cooke, Elan’s CFO, told the Wall Street Journal in July that its arrangements with J&J contemplated the possibility of the two companies working together to buy Biogen’s Tysabri stake if Biogen is acquired by a third party. Biogen protested that Elan’s proposed deal ran afoul of the companies’ collaboration agreement for the multiple sclerosis drug Tysabri. A defiant Elan filed a complaint in federal court requesting a declaratory judgment that it had not violated the collaboration agreement and a permanent injunction prohibiting Biogen from terminating their partnership. After five hours of oral argument, U.S. District Court Judge Deborah Batts ruled that the Elan-J&J partnership infringed the Tysabri agreement. 

As we explained last month, the Tysabri collaboration agreement provides that if either Biogen or Elan is acquired by a third party, then the non-acquired party has the option to purchase its stake in Tysabri. The agreement also contains a customary provision prohibiting the assignment of any rights or obligations to an unaffiliated third party without the other party’s written consent. At the hearing, Biogen’s attorneys cited a confidential clause in one of the Elan-J&J agreements giving Johnson & Johnson the option to finance an Elan change of control purchase of Biogen’s share in Tysabri. The clause requires Elan to take instructions from Johnson & Johnson if it ever enters into negotiations to purchase Biogen’s stake. By granting this option to J&J, Biogen argued, Elan effectively transferred its rights under the agreement to Johnson & Johnson.   As Biogen’s attorney Michael Gruenglas put it, Elan "is no longer in the driver's seat, Johnson & Johnson is driving the car."     

Although Judge Batts concluded that “it would seem there has been a breach of the Biogen-Elan collaboration agreement,” she saw the legal issues differently. Contrary to Biogen’s characterization of the Elan-J&J pact, Judge Batts declared that Elan had not assigned any of its rights to Johnson & Johnson. Instead, Batts explained: "It appears to the court that Elan has designated an obligation it has to Johnson & Johnson by taking direction from Johnson & Johnson on the purchase price negotiations.”

Judge Batts appears to have based the rationale for her decision on redacted portions of the Tysabri agreement’s “change of control” provision. The version of the collaboration agreement filed with the SEC details Biogen’s and Tysabri’s acquisition rights upon a change of control in the other party. But the publicly available version of the contract omits important clauses relating to the conduct of negotiations once the non-acquired party exercises its acquisition rights.   This version of the contract reads: “[i]n the event the Non-Acquired Party exercises its election [sic] to purchase the interest of the Acquired Party under this Agreement, the Parties shall…”, but then expunges the next 36 lines of the change of control provision. Significantly, the excised portions address how the companies are to proceed in the event that the non-acquired party decides to acquire the other party’s Tysabri stake. From Judge Batt’s justification for her ruling, it appears that these omitted clauses specify how pricing and other negotiations should be conducted.   

By putting the power of the purse strings in J&J’s hands, Judge Batts determined that Elan had effectively delegated its negotiating power to Johnson & Johnson.   Under the Tysabri agreement, Elan has a right to exercise its change of control purchase option, but it also has a corresponding obligation to negotiate with Biogen on such matters as the valuation of Biogen’s stake in the drug. According to Judge Batts, when Elan agreed to let J&J dictate the terms of those negotiations, it violated the “no assignment” provision of the collaboration agreement by transferring this obligation to Johnson & Johnson.       

As part of her ruling, Judge Batts remarked that Biogen was within its rights under the Tysabri agreement to give Elan a chance to rectify its breach and noted that Elan had 23 days left in the agreement’s 60-day cure period. The Wall Street Journal reports that Johnson & Johnson and Elan have been discussing ways to amend their cooperation agreement so as to avoid violating the Elan-Biogen Tysabri partnership.   Proposals by Johnson & Johnson include reducing their investment in Elan by as much as $100 million.   

Related Post: Pharma Contractual Dispute: Biogen and Elan to See Each Other in Court

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A billion dollar drug. A change of control. A collaboration agreement. And Johnson & Johnson. Sound familiar? No, we’re not talking about the Schering-Plough and J&J dispute over whether the Merck-Schering merger violates the Remicade distribution agreement. This time, Johnson & Johnson may have gone into the breach, rather than having alleged it. The case involves Massachusetts-based Biogen Idec, the Irish drug company Elan Pharma, the multiple sclerosis drug Tsyabri, and around a billion dollars in annual revenue. The question is whether Johnson & Johnson’s purchase of a minority interest in Elan violates Biogen’s and Elan’s agreement to jointly develop and market Tsyabri. 

In July, a Johnson & Johnson subsidiary entered into a set of financing and cooperation agreements with Elan worth around $1.5 billion. The agreements (which are not publicly available) would give J&J a 14.8% stake in Elan along with the option to finance Elan’s purchase of Biogen’s 50% interest in the multiple sclerosis drug Tsyabri. Under the terms of a development and marketing collaboration agreement signed by Biogen and Elan in 2000, if one of the parties to the agreement is acquired by a third-party, then the other party has the option to purchase the acquired party’s rights to Tsyabri. So why has Elan offered Johnson & Johnson this option to finance a purchase that may not ever happen?   

Elan, it seems, has been keeping a watchful eye on Biogen’s shareholders. Back in June, Carl Icahn – who has a 5.6% stake in Biogen – succeeded in getting two of his four nominees on Biogen’s board of directors. Icahn’s victory came after a fierce proxy battle waged over the course of six months. Although Icahn’s broader platform, which included moving the company’s state of incorporation to North Dakota, did not receive support from the board, there are no signs that the activist shareholder plans on relenting any time soon. On the contrary, Icahn has indicated that he intends to promote a sale of the company. By cozying up to Johnson & Johnson, Elan can ensure it has quick access to capital should Biogen suffer a change of control.   

Biogen was clearly troubled by the prospect of a big pharma player getting too close to its Tsyabri partner. If Biogen were to lose its rights to Tsyabri under the collaboration agreement’s change of control provision, the company’s value would sink. In what can only be a signal that communication channels between Biogen and Elan have broken down, Biogen sent off a July 28 letter to Elan alleging that the Elan-J&J partnership would materially breach the collaboration agreement. Specifically, Biogen claims that Johnson & Johnson’s option to finance a change of control purchase by Elan violates the collaboration agreement’s prohibition that neither party may assign or delegate any of its rights or obligations under the agreement without the written consent of the other party. Under the agreement, a material breach would initiate a 60-day cure period, at the end of which Biogen could terminate the collaboration agreement and take over Elan’s rights to Tsyabri. 

On August 6, Elan responded by filing a complaint in a Manhattan federal court seeking a preliminary injunction staying the 60-day period and a ruling that Elan’s and Johnson & Johnson’s arrangement does not breach the Tsyabri collaboration agreement. A federal judge in Manhattan has set a hearing for August 31.   

Without being able to review the Elan-Johnson & Johnson agreements, it’s difficult to assess whether or not their terms violate the Tsyabri collaboration agreement. From Elan’s own description of the agreements, however, we can presume with reasonable confidence that the issue will boil down to whether Johnson & Johnson’s option to finance an Elan change of control purchase of Biogen’s Tsyabri stake is equivalent to an assignment or delegation of Elan’s rights under the collaboration agreement. After reviewing the Tsyabri collaboration agreement, it doesn’t seem that the Elan-J&J deal violates the no assignment provision. 

Of course, we’ll be able to hear the opinion of a federal judge on the matter shortly.      

Update: Elan Loses to Biogen in Court for Assigning Tysabri Obligations to Johnson & Johnson

Related Posts: Merck-Schering's Reverse Merger: Change of Control Provisions in Material Contracts

                        Can Merck-Schering's Deal Structure Avert a Change of Control?

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How much would you pay for a “fair chance” at offering employment to a competitor’s top salespeople? What if you had valued the goodwill associated with these key employees to be worth nearly $3 million dollars, but was told by a court that your failure to structure an asset purchase properly entitled you to only one dollar in damages? A recent case before Delaware’s Court of Chancery illustrates how disciplined deal management by a company’s executive officers and thoughtful planning by legal counsel are essential to securing a buyer’s rights to the intangible business asset of human capital.

When the CEO of Ivize LLC, strode into the former Milwaukee offices of one of his company’s chief rivals on July 27, 2007, he was stunned to find the office in disarray and the absence of the branch’s manager and two top sales associates. Just the previous day, he had closed an asset purchase deal in which his company bought the Kansas City and Milwaukee branches of Compex Litigation Services for $3.4 million. As an established, nationwide provider of litigation support services to law firms and other clients, Ivize placed little value in Compex’s proprietary software, business model, or trade secrets. Instead, its CEO was primarily interested in buying what he regarded as Compex’s most valuable asset: its customers.

Ivize accordingly allocated approximately $2.9 million of the purchase price for Compex’s two branches to goodwill associated with the transferred businesses. With respect to Compex’s Milwaukee office, the goodwill in concrete terms meant the customer relationships developed by its two top salespeople, who respectively accounted for 65% and 35% of the branch’s sales. Where, he wondered as he gazed around in disbelief at Compex’s largely abandoned offices, were the top salepeople? 

Equally puzzling to the CEO was the disappearance of Compex’s Milwaukee branch manager. The CEO had been led to believe that the manager had accepted Ivize’s offer of temporary employment during a brief post-closing transition period coupled with a severance payment of one year’s salary. What the CEO didn’t know was that shortly after Ivize and Compex signed a letter of intent on March 5, 2007, Ivize’s Chief Operating Officer and Compex’s CEO told the manager that if the asset purchase transaction successfully closed the combined Milwaukee businesses would be run by his longtime professional rival.          

Not surprisingly, the manager bristled at the news that he would soon lose his job to a business competitor. While Ivize conducted due diligence on Compex’s Kansas City and Milwaukee businesses, the manager used his position as a branch manager to undermine the transaction. He immediately informed Compex’s Milwaukee employees of the prospective buyout and told them he intended to start up his own litigation support services company. Over the next several weeks, the manager successfully solicited the top salepeople to join his new venture, held meetings to discuss his business plans on Compex’s premises, redirected some of Compex’s business to his new company, pilfered customer records, and stole company equipment.  

Eventually, the CEO succeeded in winning back some of Compex’s former customers, but in spite of his efforts the Milwaukee office’s sales slumped by 45%. Ivize sued Compex in the Delaware Court of Chancery for breaching its representation in the asset purchase agreement that “since April 1, 2007 [Compex] has operated only in the usual and ordinary course.” After reviewing the agreement and the conduct of the parties, the court determined that Ivize had in fact bargained for the physical assets of Compex, such as its computer equipment and office leases, and for “a fair chance at retaining the employees of Compex (who were the “essence” of the business) – not a contractual right to sign the employees to employment and/or non-competition agreements.” 

The court explained that Ivize could have structured the transaction so that the execution of employment and non-competition agreements with Compex’s primary salespeople was a condition to closing, which would have strengthened Ivize’s contractual rights under the asset purchase agreement. More important, it would have allowed Ivize to walk away from the deal rather than sink several million dollars into a quickly evaporating pool of goodwill. If Compex’s employees had signed employment and non-competition agreements with Ivize prior to the transaction’s closing, Ivize could have pursued the top salespeople and other defecting employees under the terms of those agreements. 

Although the court held that Compex breached its “ordinary course” representation in the asset purchase agreement, it nevertheless declared that “Ivize should not be rewarded with the same damages it would have been entitled to had it structured the agreement properly.” Because Ivize was not able to establish compensatory damages to the court’s satisfaction, the court awarded $1 dollar in nominal damages as a token acknowledgement of a technical injury. 

In its opinion, the Court of Chancery focused on how an inadequate deal structure curtailed Ivize’s remedies under the asset purchase agreement. But Ivize’s executive officers could have averted the need for appropriate contractual remedies if they had managed the deal properly. Given that the asset purchase agreement was signed on the transaction’s closing date, the CEO should have ensured that Ivize had executed employment and non-competition agreements with Compex’s key employees in hand prior to signing the agreement.  The irony is that while Ivize’s executives recognized the importance of goodwill generated by human capital, they did not understand the nature of goodwill associated with customer relationships and consequently failed to take appropriate actions to protect the company from the inherent dangers in bargaining for such an intangible asset.

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A recent article in the Wall Street Journal points to a ruling of the Tax Court that lets an active investor in a limited liability company (LLC) offset his losses in the LLC against income from other sources, including compensation and investment income. The Tax Court ruled that a set of “temporary” guidelines, in place since 1988, which let an active investor in a limited partnership (LP) offset losses against other income, should also apply to an LLC investor.

The ruling is good news for “active” investors, although it will have little impact in the larger world of private equity, where most investors are passive. That’s because the criteria for being deemed an “active” participant in a business are quite stringent. The investor must have “regular, continuous and substantial involvement” in the business. In the case of limited partners in an LP, under the temporary regulations, active participation can be established only if one of the following criteria is met:   

(1) The individual participates in the activity for more than 500 hours during such year;

(2) The individual materially participated in the activity for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year; or

(3) The activity is a personal service activity, and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year.

Oddly, given the huge popularity of LLCs over the past decade, the IRS has never expanded these guidelines to make them applicable to LLCs in the same way as LPs. The recent ruling of the Tax Court fixed that. Now, because the Tax Court ruling has national impact, an LLC member who meets one of the criteria cited above can offset his allocable share of the losses in the LLC against any other income.  Before, those losses would be trapped in the LLC, possibly never to be utilized.

The fact that the IRS never got out in front of this issue is remarkable. Instead, the taxpayers here (Nebraska farmers) had to litigate with the agency for years and the Tax Court had to write a lengthy opinion to fill the gap.

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On May 27^th, Schering-Plough and Merck provided an “update” on the status of their dispute with Johnson & Johnson over the valuable Remicade distribution agreement between J&J’s Centocor subsidiary and Schering-Plough.  We previously wrote about this dispute, which centers on whether J&J has the right to terminate the distribution agreement under a “change of control” provision, and thereby capture sole rights over the international distribution of Remicade.  The press release confirmed that J&J instituted arbitration proceedings under the distribution agreement, which could go on for 9 to 12 months.  The deal will go ahead despite the outcome of the arbitration, as the possible termination of the distribution agreement was excluded from the “material adverse effect” condition in the merger agreement.

 As others have noted, the complex reverse merger structure adopted by Schering-Plough and Merck seems specifically designed to escape one of the two competing definitions of “change of control” in the distribution agreement.  Despite the merger parties’ insistence that J&J’s case “is contradicted by the clear language of the Remicade distribution agreement”, the outcome was uncertain enough to warrant a prominent risk factor in the Form S-4 registration statement filed by Schering-Plough. That disclosure includes the not-so-subtle suggestion that a settlement is likely: 

“[D]ue to the uncertainty surrounding the outcome of any threatened or actual proceeding, the parties may choose to settle a dispute under mutually agreeable terms.  Any agreement reached with Centocor to resolve a dispute under the distribution agreement may result in the terms of the distribution agreement being modified in a manner that may reduce the benefits of the distribution agreement to the combined company.”

Given the amount at stake ($2.1 billion annual revenue), the strangely ambiguous language of the distribution agreement, and the conciliatory nature of arbitration, it seems that a negotiated settlement is the most likely outcome.

Related Posts: Merck-Schering’s Reverse Merger: Change of Control Provisions in Material Contracts

                         Can Merck-Schering’s Deal Structure Avert a Change of Control?

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We were recently quoted in the online version of the Wall Street Journal in a piece about Merck's pending merger with Schering-Plough.  You can read the article here.  Thanks to reporter Peter Loftus for the mention!

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A recent opinion issued by the Delaware Court of Chancery serves as a cautionary tale to entrepreneurs, venture capitalists, and others entering into LLC operating agreements in connection with start-up companies. A minority investor with a substantial stake in a company sought to dissolve the company on the grounds it had abandoned its original business plan. However, because the purposes of the LLC were worded quite broadly in the operating agreement, the court ruled against the dissolution, much to the frustration of the minority investor. Thanks go to Francis Pileggi for bringing the case of In re: Arrow Investment Advisors, LLC to my attention and providing, as usual, an excellent summary and analysis of the court’s opinion on his blog. 

 Along with two others, Noah Hamman co-founded Arrow Investment with the intention of offering advisory services to investment funds. Hamman, who held a 30% membership interest in the company, had been its CEO until he was removed by his two fellow founders as a result of disagreements over management decisions. Like many other financial services firms, Arrow’s prospects began to sink with the market’s. In response, Arrow’s management committee decided to explore other investment opportunities and sent out a notice to the company’s members requesting capital contributions to fund their new programs. Hamman disagreed with this approach and brought a petition before the Court of Chancery seeking dissolution of the LLC under §18-208 of the Delaware LLC Act, alleging that Arrow had departed from the business strategy set out in its original business plan.  

 The court noted that Arrow’s LLC operating agreement, and not its business plan, was the controlling document for determining the company’s purpose. Arrow’s operating agreement clearly stated it was formed “for the purpose of acting as an investment adviser to certain investment funds and for such other lawful business as the Management Committee chooses to pursue.” Given the broad formation clause of the operating agreement, the court ruled that Arrow’s management had not violated the purpose for which the company had been formed simply by choosing to pursue new business strategies. In the words of Vice Chancellor Strine:

Dissolution of an entity chartered for a broad business purpose remains possible upon a strong showing that a confluence of situationally specific adverse financial, market, product, managerial, or corporate governance circumstances make it nihilistic for the entity to continue. 

A company suffering disappointing financial returns resulting from a downturn in general economic conditions did not meet this standard.    

For most companies, including a broad purpose of formation clause in the operating agreement makes sense because it provides management with flexibility to adapt to changing business conditions. But founders of start-up companies should accept that the company’s eventual trajectory may not follow the one they initially conceived. 

To address this unknown and unknowable future, LLC operating agreements can institute appropriate governance procedures and potential exit provisions that would allow management and the company’s members to resolve significant disputes, or, if necessary, to part ways. Members of LLCs with substantial minority stakes, for example, may be given veto rights over certain material managerial decisions (such as when capital calls may be made to fund new business ventures) or exit rights that would allow a withdrawal from the LLC under narrowly specified conditions.        

Nobody won in the case of Arrow Investment Advisors. Hamman remains bound to a company he no longer wants to be a part of, management must continue to deal with a contrary minority investor, and the LLC itself has lost valuable time and money in defending this lawsuit. 

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The recent decision of the Delaware Court of Chancery in the case brought by United Rental against the acquisition vehicles formed by Cerberus Capital imposes an affirmative duty to be forthright, or not devious, in the process of contract negotiations. The ruling seems to undo decades, if not centuries, of negotiating wisdom and practice. 

The United Rental court was unable to dispose of the case on summary judgment, as the contract interpretations offered by both sides were plausible. Because no decision as a matter of law could be reached, the court had to delve into the real intention of the parties on the issue whether they intended to provide a specific performance remedy.

To do this, the court heard testimony from 7 witnesses over a 2 day period. United Rental had the burden of proof to show that the parties intended to allow the remedy of specific performance, rather than the $100 million termination payment offered by Cerberus.

After all this testimony, the court remained unable to determine the shared objective intent of the parties. It therefore proceeded to adopt the breathtaking “forthright negotiator” principle:

“in cases where an examination of the extrinsic evidence does not lead to an obvious, objectively reasonable conclusion, the Court may apply the forthright negotiator principle.  Under this principle, the Court considers the evidence of what one party subjectively “believed the obligation to be, coupled with evidence that the other party knew or should have known of such belief.” In other words, the forthright negotiator principle provides that, in cases where the extrinsic evidence does not lead to a single, commonly held understanding of a contract’s meaning, a court may consider the subjective understanding of one party that has been objectively manifested and is known or should be known by the other party.”

Calling the negotiations “deeply flawed”, because both sides “failed to clearly and consistently communicate their client’s positions”, the Court found that United Rental’s attorney “categorically failed to communicate that United Rental believed it preserved a right to specific performance”. The Cerberus attorney, on the other hand, did clearly communicate his understanding that the agreement precluded specific performance. Because the United Rental lawyer did not continue to repeat his view that the agreement provide for specific performance, and relied instead on the fact that the agreement contained inconsistent provisions, he failed to satisfy the “forthright negotiator” principle.

It may come as a shock to corporate attorneys that deviousness has been barred from contract negotiations. Yet that is law of Delaware:  “United Rental knew or should have known what Cerberus’s understanding of the Merger Agreement was, and if it disagreed with that understanding, it had an affirmative duty to clarify its position in the face of an ambiguous contract with glaringly conflicting provisions."

A duty indeed!

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As this website predicted on November 24th, the Delaware Court of Chancery on December 21, 2007 found that the sole and exclusive remedy of United Rental was the $100 million break up fee specifically provided for in the Merger Agreement with entities controlled by Cerberus Capital.

The exchange of drafts and the meetings between the parties indicated that the breakup fee was intended to preclude any other remedies, including specific performance..  United Rental’s case was based on the fact that the contract continued to have language providing for equitable remedies like specific performance, even though other sections said that this remedy was superseded by the breakup fee. In deposition, the Cerberus attorney conceded that it would have been “clearer” to delete the specific performance section altogether.

Given the relatively clear cap on exposure in the Merger Agreement, one would expect that the opinion of the Delaware court would stick closely to the express contract language and the law of summary judgment. In fact, most of the opinion does that. But the court ultimately relied on an interesting though obscure principle of contract interpretation called the “forthright negotiator principle.”

According to the court, under the forthright negotiator principle, “the subjective understanding of one party to a contract may bind the other party when the other party knows or has reason to know of that understanding. Because the evidence in this case shows that defendants [Cerberus] understood this Agreement to preclude the remedy of specific performance and that plaintiff [United Rental] knew or should have known of this understanding, I conclude that plaintiff has failed to meet its burden and find in favor of defendants.”

“The forthright negotiator principle provides that, in cases where the extrinsic evidence does not lead to a single, commonly held understanding of a contract’s meaning, a court may consider the subjective understanding of one party that has been objectively manifested and is known or should be known by the other party.”

The only support for this principle cited by the court was a section of the Restatement of Contracts. 

The very interesting history of these contract negotiations indicates that the parties never explicitly resolved the issue of whether the $100 million breakup fee was the sole and exclusive remedy. The court found that because the parties never clearly drafted any agreement on the termination fee, it would award judgment to the side that most clearly and consistently articulated its subjective understanding of the agreement to the other side. In this, the court found that the Cerberus attorney was more consistent in his statements that the termination fee was intended to preclude specific performance. The attorney for United Rental, the court found, implicitly agreed with the Cerberus position during oral contract negotiations.

The case came down to this fact: “Though URI, through [its lead attorney], had many opportunities throughout the negotiation process to clearly vocalize its understanding of its rights for specific performance under the Merger Agreement, URI consistently failed to communicate this to Cerberus representatives.”

The very interesting implications of this decision for the manner in which merger negotiations are conducted will be the subject of future postings here.

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Does Cerberus have the unilateral right to walk away from its deal with United Rental and limit its exposure to a break up fee of $100 million?  Or does United Rentals have the right to specifically enforce the merger agreement?  That's the issue at the heart of lawsuits currently pending in Delaware and New York arising out of this failed acquisition. 

Cerberus had this to say about United Rental's Delaware action for specific performance in a press release issued November 19th:

"We believe that United Rentals has been less than forthright in its legal filings and its communications concerning those filings.  The fact is that RAM negotiated for and obtained the right to withdraw from the Merger Agreement of July 22, 2007 and instead make a one-time payment in the aggregate amount of US $100 million.  This ability to walk away from the transaction with this limited exposure was specifically bargained for, is clearly and unambiguously stated in the Merger Agreement and related documentation, and is not in any way conditional on the occurrence of a material adverse change, the termination of the Merger Agreement by United Rentals or any other event."

Also, according to Bloomberg, Cerberus started its own lawsuit in New York Supreme Court seeking a declaration that its maximum exposure to United Rentals is $100 million. In the suit, Cerberus says United Rentals has no remedy other than the right to pursue the $100 million brake up fee, which serves as a cap for any or all losses or damages relating to or arising out of the merger agreement.

Let's see where that clear and unambiguous statement appears in the merger agreement.  Section 8.2(c) of the agreement says:

"In the event that this Agreement is terminated by [United Rentals] pursuant to Section 8.1(d)(i) or Section 8.1(d)(ii), then [Cerberus] shall pay $100,000,000 to [United Rentals] as promptly as reasonably practicable (and, in any event, within two business days following such termination), payable by wire transfer of same day funds."

OK then.  Section 8.1(d)(i) says that United Rental can terminate the agreement upon certain breaches by Cerberus of the merger agreement, and Section 8.1(d)(ii) says that United Rental can terminate the agreement if the merger isn't completed by a certain date.  Neither of these things has happened, and United Rentals isn't seeking the fee. 

Later on, in Section 8.2(e), there is a clause limiting liability for termination events to $100 million.  It says that United Rental's right to terminate the merger agreement under Sections 8.1(d)(i) or (ii) and receive the $100 million fee under Section 8.2(c) is the "sole and exclusive remedy" of United Rentals against Cerberus for "any and all loss or damage suffered as a result thereof" and Cerberus shall not have "any further liability or obligation of any kind or nature relating to or arising out of this Agreement or the transactions contemplated by this Agreement as a result of such termination."  This fee is "the sole and exclusive remedy for recovery" in the event of "the termination of this Agreement by [United Rentals] in compliance with the provisions of Section 8.1(d)(i) or (ii)."  

So far, it looks as though United Rentals has the winning position, as this language pretty clearly says that the $100 million payment is the sole remedy only in the situation where United Rentals has terminated the merger agreement due to a misrepresentation or failed deadline.  Up until now, there isn't any absolute cap on liability if Cerberus breaches the agreement and walks away.

But keep reading.  At the very end of Section 8.2(e), comes the provision that finally supports Cerberus:

"In no event, whether or not this Agreement has been terminated pursuant to any provision hereof, shall [Cerberus], either individually or in the aggregate, be subject to any liability in excess of [$100 million] for any or all losses or damages relating to or arising out of this Agreement or the transactions contemplated by this Agreement, including breaches by [Cerberus] of any representations, warranties, covenants or agreements contained in this Agreement, and in no event shall [United Rentals] seek equitable relief or seek to recover any money damages in excess of such amount from [Cerberus].

That's pretty clear.  Although there is plenty of language in the agreement that appears to support United Rentals' position, this one sentence appearing at the end of Section 8.2(e) seems to cap Cerberus' exposure at $100 million.   The stock market seems to agree as well.

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Knowing how to get out of a deal is often as important as knowing how to get in.  When a company blows up, it's easy to find a representation that went awry.  But when things turn sour because of legislation or macro economic issues, you've got to look at the MAC clause.

The MAC, or material adverse change, clause sets the conditions under which a deal may be terminated without penalty. MAC exceptions, which are often appended to such clauses, outline specific circumstances under which the MAC doesn't apply, meaning the deal must proceed even if there is a material change.

During the deal frenzy of the past several years, sellers have had the upper hand in negotiating deal terms, a trend that has extended to the MAC clause. To win deals, buyers have agreed to loose MAC clauses with lots of exceptions, or in some cases have foregone MACs altogether.

The litigation currently pending in Delaware between SLM (Sallie Mae) and J.C. Flowers & Co. will, if it goes that far, shape the understanding of MAC clauses for the next few years.  J.C. Flowers and its partners have sought to walk away from the deal, in part on the basis that new Federal legislation will decrease the earning of the company.  SLM has of course insisted that the deal must go through, and issued a press release saying that "core earnings" at the company will be negatively impacted by only 1.8 to 2.1 percent annually over the next 5 years.  The issue is whether the MAC clause is triggered by the adverse impact of the new Federal legislation.  The clause reads as follows:

"Material Adverse Effect" means a material adverse effect on the financial condition, business, or results of operations of the Company and its Subsidiaries, taken as a whole, except to the extent any such effect results from: ... (b) changes in Applicable Law provided that, for purposes of this definition, "changes in Applicable Law" shall not include any changes in Applicable Law relating specifically to the education finance industry that are in the aggregate more adverse to the Company and its Subsidiaries, taken as a whole, than the legislative and budget proposals described under the heading "Recent Developments" in the Company 10-K, in each case in the form proposed publicly as of the date of the Company 10-K) or interpretations thereof by any Governmental Authority..."

As the highlighted language shows, SLM and JC Flowers were acutely aware of the potential impact of the new Federal legislation on the earnings of Sallie Mae.  This was not a thunderbolt from out of the blue.

SLM's position is that the "core earnings" of the company will only be reduced by 1.8 to 2.1 percent  MORE than what was already presented in the 10-K.  This sets the bar well under the 10% figure which most lawyers and judges would agree is "material".  As the M&A Law Prof Blog points out, the Delaware courts set a high bar for proving a MAC.  Under these cases the party asserting a MAC has the burden of proving that the adverse change will have long-term effects and must be materially significant.

Of course the issue may be settled before any trial.  Justine Strine has been pressing the sides to settle.  A renegotiated price is the likely outcome, as SLM will not likely want to remain in the public eye after this battle.

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What do you call a guy who gives you a non-binding letter of intent to buy your company for $15.5 million, waits a few months before giving you another non-binding letter, and then sues you when you sign a binding contract to sell your company for $30.5 million?  In Nebraska, he’s called Kelly Conolly.

Conolly worked as a terminal manager for Clark Brothers Transfer, a trucking company based in Nebraska.  James Clark was the company's president and majority shareholder.  In early 2003, Conolly began talking with Clark about buying the company.  After months of negotiating, they executed a confidentiality agreement on October 17, 2003, which gave Conolly financial information about the company.  Clark asked Conolly to give him a written purchase offer in 2 weeks.  Conolly sent another non-binding letter of intent without a purchase offer.  The letter also left the purchase price open.

Clark and Conolly met the next day, orally agreed on a purchase price of $15.5 million, shook hands and left all the other terms open. Clark asked for a firm purchase offer within two weeks.  Six weeks later, Conolly's attorney sent a letter saying Conolly was interested in purchasing the company "pursuant to the terms contained in this non-binding letter of intent."  The letter named a price but reiterated that it was not a binding commitment by either party.  Conolly sent Clark an email stating, "of course this is just preliminary and a formal proposal will be forthcoming once we reach an agreement."  Six weeks later, Clark sold the company to another buyer for $30.5 million.

Conolly argued that the parties had a contract when they agreed on the price and shook hands.  The United States Court of Appeals for the Eighth Circuit held that that the terms of the oral agreement were not “sufficiently definite to demonstrate an objective intent to be bound” at the time the parties shook hands.  The parties were still negotiating many basic terms. 

Wikipedia says that chutzpa is the quality of audacity, for good or for bad.  That may be the right word.

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The Third Circuit Court of Appeals in Philadelphia recently decided an important case concerning whether a leverage spin-off can be attacked under fraudulent conveyance rules in bankruptcy.

In 1998 Campbell Soup Co. dropped the assets of its Vlasic pickle and Swanson dinner businesses into a newly formed subsidiary, and paid itself a $500 million cash dividend with funds borrowed against the assets. Campbell then spun out the new company to its stockholders, and Vlasic became a free-standing public company. Unfortunately, the pickle and frozen dinner businesses suffered and within 3 years of the spin off, Vlasic was in bankruptcy.

The trade creditors of Vlasic argued that the payment of the dividend to Campbell at the time of the spin off was a "constructively fraudulent transfer".

In orchestrating the spin-off, Campbell “negotiated” with the people who were to manage the business, but it would not take less than a $500 million cash payout. There was lots of evidence that Campbell massaged the businesses before the spin out to achieve the biggest cash payout possible. Vlasic had to restructure its debt shortly after the spin off, but went on for a year or so to operate relatively well.   In fact, the public markets valued the equity of Vlasic at $1 billion, even with the $500 million debt.

As the court said, the company did not collapse, but rather slowly declined. The game ended a little more than 2 years after the spin off.  At trial, the issue was whether the assets of Vlasic were “reasonably equivalent value” for the $500 million payment made to Campbell. Based on the fact that Vlasic traded at a $1 billion market value after the spin off, the trial court answered “yes”. 

The bankruptcy creditors tried to argue that Campbell’s prior manipulations had a lingering effect on the market value of the company after the spin off.  The Court of Appeals didn’t buy the argument, referring repeatedly to the fact that public investors valued the company at $1 billion after the spin off.

Soup's on!

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In a recent case from Delaware’s chancery court, the clear language in a merger agreement, controlling dispute resolution matters, was enforced by the court even where the method specified wasn’t the best way to resolve the dispute. The case underscores the importance of thinking carefully about the implications of arbitration clauses, and especially how two or more arbitration schemes relate to each other.

Matria Healthcare entered into an agreement to acquire CorSolutions Medical for $445 million. Both companies were engaged in the disease management business. Nearly 5% of the purchase price ($20.3 million) was set aside in an escrow account to satisfy claims that the closing net working capital of CorSolutions fell short of a minimum target. The escrow account was also available to satisfy claims under the indemnification provisions, including breaches of representations and warranties.

Whether a claim fell under the working capital adjustment or the indemnification claim was critically important, as indemnification claims were subject to a threshold of $4.45 million, while claims for a working capital adjustment were not subject to any threshold. There was an important procedural difference as well. Claims concerning the closing net working capital were to be resolved solely by a specific accounting firm. Indemnification claims were to be resolved in accordance with the Commercial Arbitration Rules of the American Arbitration Association, which give the parties the ability to challenge and investigate claims.  

The parties saw ahead of time that disputes involving, for example, misrepresentations could fit within both arbitration schemes. They decided that any matter relating to the closing working capital had to be resolved by the accounting firm mechanism, even though the matter could also be raised as a misrepresentation under the AAA procedure.

Shortly after the closing, a messy dispute arose involving a customer of CorSolutions. The customer instituted an audit of a CorSolutions disease management program. Matria dealt with the matter after the closing by negotiating a resolution with the client that involved, among other things, a cash payment of $1.5 million and amendments to the customer contract. Matria applied the $1.5 million payment as a debit to the closing working capital and asserted a claim against the escrow account.

The dispute could have been raised as both a working capital adjustment and a claim for indemnification. CorSolutions thought the working capital arbitration was too narrow a context to allow a full airing of the issues, and it asserted that the AAA was the only proper place to hear the dispute. It also, of course, wanted the claim to be subject to the $4.45 million threshold for indemnification claims.

The court agreed in substance with CorSolutions, but ruled in favor of Matria, on the strength of the clear hierarchy of arbitration contained in the merger agreement. Even though the dispute was one that typically would be subject to an indemnification threshold, the clear hierarchy of arbitration procedures forced the claim into the working capital adjustment, for which there was no threshold. Clever drafting by Matria’s attorneys.

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