Do Post-Closing Merger Price Adjustments Comport With DGCL?
Delaware courts have routinely upheld post-closing merger price adjustments that comply with the requirements of Section 251 of the Delaware General Corporation Law. To allow stockholders to make an informed decision as to whether to accept the merger consideration, or seek appraisal, Section 251 requires that the value of the "cash, property, rights or securities ... which the holders ... are to receive" as consideration in the merger be determinable or ascertainable by the stockholders at or about the time of the merger. Section 251(b) permits, however, the value of the merger consideration to be determined or ascertained from "facts" outside of the merger agreement, including the "occurrence of any event ... a determination or action by any person or body, including the corporation." For example, upward, post-closing price adjustments for earnouts based on the performance of the seller over a definite period of time after the closing are common in private-company mergers, and have been upheld by the Court of Chancery under DGCL Section 251(b), as in Aveta v. Cavallieri, 23 A.3d 157, 178 (Del. Ch. 2010). Similarly, escrow provisions, in which a portion of the merger consideration is held back and remains subject to claims of the buyer for a certain period of time after the closing, are also common in private-company mergers, and widely accepted as permissible post-closing price adjustments under DGCL Section 251(b). (See, e.g., In re OPENLANE Shareholders Litigation, C.A. No. 6849-VCN (Del. Ch. Sept. 30, 2011).)
Under Section 251, stockholders surrender their shares for cancellation in return for the benefit of the merger consideration. In an earnout approach, stockholders receive the benefit of a portion of the merger consideration up front, and have the possibility of receiving additional merger consideration or future benefits based on the performance of the seller over a period of time after the closing. In an escrow approach, the stockholders also receive the benefit of a portion of the merger consideration up front, and have the possibility of receiving additional merger consideration or the future benefit of the amount of the merger consideration held back in escrow depending on whether the buyer successfully asserts a claim against the escrowed funds. In contrast to a benefit for their canceled shares, an indemnification or clawback approach leaves the stockholders with a potential liability or obligation to return the merger consideration at some later time if the buyer successfully asserts a claim under the indemnification obligation in a merger agreement. But, as the Court of Chancery noted in its recent decision in Cigna Health and Life Insurance v. Audax Health Solutions, C.A. No. 9405-VCP (Del. Ch. Nov. 26, 2014), query whether the indemnification or clawback approach comports with the two-way exchange concept in Section 251, in which the stockholders surrender their shares in exchange for the benefit, not liability for further obligations, of the corresponding merger consideration. The court noted that very few Delaware cases have, however, addressed the propriety of post-closing price adjustments for indemnification or clawbacks.
In Cigna Health and Life Insurance, the court held that a merger agreement's indemnity obligation for seller Audax Health Solutions Inc.'s potential breach of representations and warranties left Audax's stockholders with a potential obligation to the buyer Optum Services Inc. to return the entire amount of their merger consideration for an indefinite period of time, and therefore rendered the true value of the merger consideration unascertainable or unknowable by Audax's stockholders in violation of Section 251(b). Further, the court held that a post-closing condition, which required Audax's stockholders to give a release of any claims against Optum to receive the merger consideration, was unenforceable because the release condition was a new obligation, not included in the merger agreement, and thus not supported by consideration since Optum had a preexisting duty to pay the merger consideration upon the surrender of Audax stockholders' shares.
Optum acquired Audax by merger. Before the merger, the plaintiff stockholder owned shares of Audax's Series B Preferred Stock. On Feb. 10, a majority of the Audax board of directors approved the merger with Optum. On Feb. 14, the merger was approved by written consent of 66.9 percent of Audax's stockholders entitled to vote. The plaintiff stockholder did not vote in favor of the merger. The merger was consummated pursuant to Section 251.
After consummation of the merger, Optum refused to pay the plaintiff the merger consideration because the plaintiff refused to agree to Optum's letter of transmittal. The merger agreement conditioned receipt of the merger consideration by Audax's stockholders on surrender of their shares and execution of a letter of transmittal acceptable to Optum. In turn, the letter of transmittal required the plaintiff stockholder to give Optum a release of any claims as a post-closing condition of the merger, which was not contained in the merger agreement. The letter of transmittal also required that the plaintiff agree to the terms of the merger agreement, which included an indemnity obligation for Audax's potential breach of representations and warranties. The indemnity obligation imposed potential liability on Audax's stockholders for an unlimited period of time to return to Optum up to the entire amount of the merger consideration received by them.
Before the court was the plaintiff stockholder's motion for judgment on the pleadings on the grounds that the release obligation was unenforceable for lack of consideration and the indemnity obligation violated Section 251.
Indemnity Provision Violated Section 251(b)
The court ruled that the indemnity obligation in the merger agreement violated Section 251(b). While the indemnity obligation for Audax's potential breach of representations and warranties complied in a literal sense with the "facts ascertainable" provision of Section 251(b), which permits reference to facts outside of the merger agreement to ascertain the value of the merger consideration, the true value of the merger consideration itself was not, in fact, ascertainable, either precisely or even within a reasonable range of values. Indeed, the court explained that the merger consideration would never become firm or subject to determination with any degree of certainty. Instead, in evaluating the value of the merger consideration relative to their potential indemnification obligation to return the entire amount of the merger consideration, Audax's stockholders are left for an indefinite period of time with making difficult estimates of their potential liability and damages for any Audax breach of the representations and warranties. In short, because the entire amount of the merger consideration received by the plaintiff stockholder remained subject to incalculable potential claims for indemnity for an indefinite period of time, the merger consideration was "aptly ... described an open-ended post-closing price adjustment," which rendered the true value of the merger consideration unknowable. Accordingly, because the indemnification obligation prevented the Audax stockholders from determining the value of the merger consideration, the court ruled that the indemnification obligation violated Section 251(b)'s requirement that a merger agreement state "the cash, property, rights or securities of any other corporation or entity which the holders of such shares are to receive."
The court was careful, however, to preserve the viability of the common practice of using post-closing price adjustments in escrow provisions in its ruling. Further, the court left open the issues of whether a price adjustment that covers all of the merger consideration may comply with Section 251(b) if time-limited, or whether an indefinite price adjustment as to some, but not all, of the merger consideration would be valid. The court emphasized that its decision to invalidate the price adjustment for the indemnification obligation was based on the combination of indefinite length and contingent nature of the entirety of the merger consideration that rendered the value of the merger consideration unascertainable in violation of Section 251(b).
The court found the release obligation in the letter of transmittal to be a new obligation not contained in the merger agreement that Optum sought to impose on the plaintiff stockholder post-closing. Because nothing new was being provided to the plaintiff beyond the merger consideration, to which the plaintiff became entitled when the merger was consummated and its shares canceled, there was no consideration to support the release obligation in the letter of transmittal. In rejecting Optum's argument that the release obligation was part of the "bundle of rights" that Audax stockholders were required to provide in exchange for the right to receive the merger consideration, the court explained that if the "bundle of rights" theory of consideration was correct then "buyers could impose almost any post-closing condition or obligation on the target company's stockholders after the fact by including it as a requirement in a letter of transmittal." The court pointed out that this possibility was "troubling," and ruled that the release obligation was unenforceable based on the lack of consideration.
Post-closing price adjustments are enforceable in a merger agreement if the true value of the merger consideration remains ascertainable or determinable, so as to enable stockholders to make an informed decision as to whether to accept the merger consideration in exchange for the surrender of their shares, or seek the remedy of appraisal.