Parties who at the signing of a merger agreement are eager to close may have a change of heart if intervening adverse market conditions reduce or eliminate the economic benefits.
Those changing market conditions often do not affect the buyer and seller equally. In that circumstance one party may wish to avoid, and the other to consummate, the transaction.
A Delaware court faced with a claim for specific performance on the one hand and a request on the other for declaratory judgment that a party is excused from its contractual obligation will apply traditional principles of contract interpretation and standards applicable to an award of equitable relief. That is exactly what the Delaware Court of Chancery did in denying the plaintiff's request for specific performance in Williams Companies v. Energy Transfer Equity, C.A. No. 12168-VCG (Del. Ch. June 24, 2016), a case with instructive lessons for practitioners regarding when the Court of Chancery will decline specifically to enforce a merger agreement.
Plaintiff Williams Companies Inc. and defendant Energy Transfer Equity are both in the gas pipeline business. They entered into a merger agreement in September 2015 pursuant to which the buyer would acquire seller's assets in a complicated transaction structured to accommodate the seller's desire to have its stockholders continue as holders of publicly traded stock and to receive a substantial cash payment. To achieve this goal, the buyer created Energy Transfer Corp. (ETC), a Delaware limited partnership taxable as a corporation into which the seller would merge. As the court explained, "ETC would then transfer the former Williams assets and 19 percent of ETC's common stock to the partnership, in return for partnership units equivalent in value to the ETC stock on a one-share-for-one-unit basis, together with $6 billion in cash ... .[with] the cash then ... distributed to the former [seller's] stockholders."
The timing of the two-part transaction is important. In the first leg of the potential transaction, the buyer would transfer $6.05 billion to ETC in exchange for ETC shares representing 19 percent of ETC. ETC would then distribute the cash to the seller's stockholders. In the second leg, ETC would contribute the seller's assets to the buyer in exchange for newly issued Class E partnership units (contribution transaction).
After the signing of the merger agreement a significant decline in the value of gas pipeline assets tied to a decline in the energy market caused the buyer's publicly traded partnership units to decline by between a third and a half. This made consummating the potential transaction "financially unpalatable" due to the now higher borrowing costs to the buyer to finance a $6 billion payment to the seller. The court found that the buyer now wished to exit as strongly as it once wished to consummate the potential transaction.
In the midst of this financial distress, the head of tax at the buyer realized that, contrary to his original understanding, the number of ETC shares exchanged was not floating but fixed in the merger agreement. This meant that the buyer would receive ETC shares that were approximately $4 billion less valuable than the $6 billion the buyer was obligated to pay. The buyer's head of tax was concerned that "the IRS could attribute the excess cash to the other leg (the contribution transaction) and thus trigger taxable gain."
What made this discovery significant was that the buyer had bargained for a condition precedent to consummation of the potential transaction that the partnership's tax attorneys, Latham & Watkins, issue an opinion that the transaction between ETC and the buyer "should" be treated by the IRS as a tax-free exchange under Section 721(a) of the Internal Revenue Code. In light of this new fact, Latham & Watkins became concerned that the IRS would not view the two legs of the potential transaction as separate for tax purposes. It therefore concluded that as of the trial on June 20-21, it could not issue the required 721 Opinion.
The seller claimed that the buyer had failed to use commercially reasonable efforts to obtain the 721 Opinion. The seller also claimed that the buyer misrepresented that it knew of no facts that would reasonably prevent the tax-free treatment of the contribution transaction pursuant to Section 721(a) because it knew or should have known of the theories on which Latham & Watkins relied in concluding that a risk of tax liability precluded issuing the 721 Opinion. The seller therefore contended that the buyer is estopped from terminating the merger agreement based on the failure to obtain the 721 Opinion. The buyer in its counterclaim asserted that Latham's independent conclusion that it could not issue the 721 Opinion precluded a decree of specific performance and entitled the buyer to terminate the merger agreement.
Court Finds Latham Acted Reasonably and Independently
Critical to the court's determination that Latham acted reasonably was the absence of any record evidence that the buyer could have taken some action that would have caused Latham to issue the 721 Opinion. The court found that the buyer's head of tax bringing the issue to Latham's attention was not a violation of the "commercially reasonable efforts" clause. The court also found that the embarrassment to Latham's professional reputation for having changed its mind from the time of closing to the time of trial as to the likelihood of its being able to issue the 721 Opinion supported that its belief was sincere that it could not issue the 721 Opinion. Finally, unlike in Hexion Specialty Chemicals v. Huntsman, 965 A.2d 715, 755-56 (Del. 2008), the court found no evidence that the buyer actively and affirmatively coerced or mislead Latham to torpedo the deal.
Delaware is a contractarian state. It will enforce contracts as written. The analysis here reflects that. While the court viewed Latham's change of heart with a jaundiced eye in light of the buyer's economic motivation to avoid the potential transaction, it reviewed the record for evidence that buyer acted or failed to act in ways that prevented Latham from rendering the 721 Opinion. It found none. In that circumstance practitioners can take comfort that a Delaware court will not require a party who conditioned its performance on the likelihood of certain tax treatment to consummate a transaction when it could not obtain its contractually bargained for tax opinion to that effect. The seller has appealed the decision to the Delaware Supreme Court so further guidance may be forthcoming.