Supreme Court Applies 'Reasonable Conceivability' Test
Two important aspects of merger agreements are the price and the nature of the post-closing obligations of the sellers to defend or indemnify the buyer for claims arising out of presale conduct. As to the former, parties to merger transactions often bridge valuation gaps with earn-outs.
The selling stockholders receive a cash payment at closing and an additional contingent right to receive a specified amount of future payments depending on how well the business performs. Exactly how much is a function of the parties' written agreement. Similarly, the parties typically negotiate over the nature of the post-closing obligations of the seller to indemnify or defend. When disputes arise, parties calculate the likelihood of success in surviving a motion to dismiss for which the court's standard of review is critical. In the recent case of Winshall v. Viacom International, No. 39, 2012 (Del. Oct. 8, 2013), the Delaware Supreme Court addressed the standard on a motion to dismiss and also contractual provisions in a merger agreement regarding earn-out and indemnification provisions. Its opinion provides guidance to practitioners concerning how to draft provisions that carry out their intent on these points.
The case arose out of Viacom International Inc.'s 2006 acquisition by merger of Harmonix Music Systems Inc., a company whose business was to develop music-oriented video games. In addition to $175 million in cash payable at closing, the parties' merger agreement provided that the selling stockholders would receive a contingent right to incremental uncapped earn-out payments during 2007 and 2008 based on financial performance. The merger agreement entitled the selling stockholders to three-and-a-half times the amount by which Harmonix's gross profits (as defined in the merger agreement) exceeded specified targets in 2007 and 2008. The merger agreement did not require Harmonix to conduct its business so as to maximize the earn-out payments. The merger agreement also contained an indemnification provision requiring the selling stockholders to hold harmless Viacom and Harmonix, as the surviving corporation, and their affiliates from and against any losses arising out of or by reason of the breach of any representation or warranty of the company in the merger agreement.
When the merger closed, Harmonix was in the process of developing "Rock Band," a new video game. Six months later, in the spring of 2007, and before "Rock Band"was completely developed, Harmonix entered into a distribution agreement with a third party to distribute "Rock Band" in exchange for distribution fees. These distribution fees were a significant cost that affected the amount of the earn-out payments. Thereafter, when "Rock Band"came onto the market, its sales were so high that it threatened to increase the amount of the 2008 earn-out payment that the plaintiffs allege "gave the defendants bargaining leverage to renegotiate" the original distribution agreement. During those negotiations, the distributor offered to reduce the amount of payments due under the original distribution agreement, but the defendants did not agree to that proposal. Had they done so, the amount of the earn-out would have increased. Instead, the defendants agreed to terms that left the amount of the earn-out payment unchanged from the original agreement but, among other things, reduced distribution fees due in future years beginning in 2009.
Finally, in 2007 and 2008, Harmonix advised the selling stockholders' representative that it had received four claims for violation of intellectual property rights and demanded that the selling stockholders indemnify the defendants for the defense of those claims. The selling stockholders refused and also demanded the release of certain escrowed funds due the selling stockholders under the merger agreement. The defendants refused to consent, claiming that the selling stockholders had breached the representations and warranties under the merger agreement. Ultimately, the selling stockholders sued, claiming in Count I of their complaint that the defendants violated the implied covenant of good faith and fair dealing by not taking advantage of their opportunity to lower the distribution fees in 2008 (and thereby increase the earn-out). They also sought declaratory relief that Viacom was not entitled to indemnification and release of the escrowed funds in Counts II and III. The Court of Chancery dismissed Count I for failure to state a claim under Court of Chancery Rule 12(b)(6) and later granted summary judgment in favor of the plaintiffs on Counts II and III and ordered release of the escrowed funds. The selling stockholders appealed the dismissal of Count I and the defendants cross-appealed from the entry of summary judgment for Counts II and III. The court affirmed the lower court in all respects but only after first reaffirming the appropriate standard on a motion to dismiss.
Reasonable Conceivability Standard
In Central Mortgage v. Morgan Stanley Mortgage Capital Holdings, 27 A.3d 531, 536-37 (Del. 2011), the Delaware Supreme Court made clear that the standard for dismissal under Rule 12(b)(6) is one of reasonable conceivability—does the complaint state a claim under any "reasonably conceivable" set of facts inferable from the facts alleged in the complaint? Although the court below applied that standard, it also noted in a footnote that it could not see the difference between that standard and the federal standard articulated in Bell Atlantic v. Twombly, 550 U.S. 544 (2007), and Ashcroft v. Iqbal, 556 U.S. 662 (2009), that a complaint must "state a claim to relief that is plausible on its face." The Supreme Court criticized the lower court for attempting to reargue the issue and emphasized that the two standards are different and that Delaware's standard will remain until the issue is properly presented to the Delaware Supreme Court for reconsideration:
"The Twombly/Iqbal plausibility standard is more rigorous than Delaware's counterpart pleading standard. Longstanding Delaware case law holds that a complaint will survive a motion to dismiss if it states a cognizable claim under any 'reasonably conceivable' set of circumstances inferable from the alleged facts. These two standards are significantly different. See Jayne S. Ressler, 'Plausibly Pleading Personal Jurisdiction,' 82 Temp. L. Rev. 627, 632 (2009) ('Twombly is premised on the notion that the specificity of allegations contained in pleadings can be plotted on a spectrum with "conceivable" on one end ... and "plausible" on the other end, as the most restrictive.'); according to Central Mortgage, 27 A.3d at 537 n.13 ('Our governing "conceivability" standard is more akin to "possibility," while the federal "plausibility" standard falls somewhere beyond mere "possibility" but short of "probability."') In Central Mortgage, we concluded that, 'Until this court decides otherwise or a change is duly effected through the civil rules process, the governing pleading standard in Delaware to survive a motion to dismiss is reasonable "conceivability."'"
Dismissal of Claim
The Supreme Court for three reasons rejected the plaintiffs' challenge to the Court of Chancery's dismissal under Rule 12(b)(6) of their claim that the defendants had a duty, based on the implied covenant, to act to increase the earn-out payment when presented with an opportunity to do so during the renegotiation of the distribution agreement by agreeing to reduce the amount of the distribution fees. The Supreme Court affirmed the lower court's reasoning that: (1) there was no reason to believe that the parties would have agreed to such a provision had they thought to negotiate about it at the time of the merger agreement; (2) the defendants did nothing to increase the amount of distribution fees payable and thus to reduce the amount of the earn-out payments in 2008; and (3) the selling stockholders had no reasonable expectation that if presented with an opportunity after the merger closed to maximize the earn-out, the defendants were obligated to accept that opportunity. The court emphasized that the outcome might have been different if the defendants had chosen intentionally to increase costs during the earn-out period in exchange for reduced payments later, but that is not what occurred. The lesson for practitioners is that if the intent is for the defendants to maximize the earn-out, the plaintiffs should insist on explicit language that says so. Having not done so, the court will not rewrite the parties' agreement to supply a term the plaintiffs failed to bargain for at the negotiating table.
Agreement to Hold Harmless
The defendants failed in their attempt to persuade the Supreme Court that the merger agreement created an "independent duty to pay defense costs" incurred by Viacom in defending the third-party intellectual property claims that is separate from and "broader than the duty to indemnify." The court noted the absence of language to that effect in the contract. Further, the court explained that where "the contract expressly imposes only a duty to 'indemnify,' as opposed to 'indemnify and defend,' the courts generally hold that there is no duty to defend." Similarly, the court rejected as illogical and not supported by the text of the merger agreement the defendants' argument that their right to request indemnification created a duty to advance defense costs that was broader than the duty to indemnify.
The Winshall case is a reminder that until the Delaware Supreme Court otherwise determines, the standard on a motion to dismiss remains that of reasonable conceivability. Under that standard, Delaware courts do not lightly find a breach of the implied covenant of good faith and fair dealing, particularly when plaintiffs are arguing for protections they could have but failed to bargain for at the negotiating table. Finally, if a buyer wishes to have the selling party or its shareholders be responsible for advancing defense costs for post-merger claims, as opposed to merely indemnifying them, it should say so explicitly. The concepts of advancement and indemnification are distinct and a Delaware court will expect language reflecting the parties' intent that a seller advance defense costs and will not impose that duty based on language limited to an obligation to indemnify and hold harmless.