Court of Chancery Finds that Substantial Litigation Expenses Not a Sufficient Material Adverse Effect to Rescind a Contract
Frontier Oil Corporation v. Holly Corporation, 2005 WL 1039027 (Del. Ch. April 29, 2005).
Frontier Oil Corporation and Holly Corporation are petroleum refiners that sought to merge. In conducting its due diligence review of Frontier, Holly discovered that activist Erin Brockovich was planning to bring a toxic tort suit claiming that an oil rig that had been operating for decades on the campus of Beverly Hills High School caused the students to suffer from a disproportionately high incidence of cancer. This raised concerns for Holly because a subsidiary of Frontier had previously operated the Beverly Hills drilling facility. Although the terms of the merger agreement were modified to address the situation, including broadening the representation to apply to litigation that would reasonably be expected to have a material adverse effect ("MAE") on Frontier, the court found that substantial litigation costs were not a MAE and therefore the contract could not be rescinded.
Two developments followed after the signing of the modified agreement: the Beverly Hills litigation was commenced, and Frontier was named as a defendant, based on contractual indemnities that Frontier had earlier provided to its subsidiary, a fact not known at the time the merger agreement was signed. Thus, Frontier and Holly could no longer take any comfort in the pre-signing notion of "corporate separateness." Much negotiation followed in an attempt to keep the merger alive, but in the end the parties could not reach agreement. In the resulting litigation, the court was asked to decide whether Frontier had breached its representation that the Beverly Hills litigation "would not have or reasonably be expected to have" a MAE so as to excuse Holly's performance of the merger on the grounds that the "true and correct at closing" condition had not been satisfied.
The court found that the burden of proof rested on the party seeking to rely on the MAE to prove both that the event (here, the litigation) existed, and that it would have a MAE. In doing so, the court rejected Holly's argument that the burden was on Frontier to show that the Beverly Hills litigation would not reasonably be expected to have a MAE. The court recognized that the litigation posed serious risks in terms of defense costs and that these would be "substantial." It also recognized that the Beverly Hills litigation "could be catastrophic," with judgments of "hundreds of millions of dollars." However, the court concluded that these substantial defense costs could be borne by Frontier. In addition, Holly did not establish that "Frontier could not pay them or that their payment would have had a significant effect if viewed over the longer term."