Mergers are a popular structure for a private company acquisition for many reasons, one of which is that under Section 251 of the Delaware General Corporation Law (DGCL) and similar statutes in other states, a deal can be closed without the unanimous consent of all shareholders, as long as it is approved by the requisite number of shareholders under the company's governing documents and applicable law. This can be useful in deals where an entity is controlled by a large number of shareholders because it eliminates the need to reach out to every single shareholder, which can be a logistical challenge. It also is helpful when a minority owner is not interested in selling their interests in the company, as it offers the buyer some leverage if such minority shareholder attempts to block the transaction or negotiate additional consideration. For many years, buyers closing mergers without obtaining the consent of all shareholders have required non-signing shareholders to execute a letter of transmittal to receive their share of the merger consideration. Such letters of transmittal often included an array of various representations and covenants, such as indemnity obligations, a general release of all claims against the buying parties, and even competition restrictions. The enforceability of certain of these representations and covenants was called into question in a Delaware Chancery Court ruling, Cigna v. Audax Health Solutions (107 A.3d 1082 (2014)).
In February 2014, Audax Health Solutions, Inc. entered into a merger agreement whereby it would be acquired by a wholly owned subsidiary of Optum Services Inc. The merger was approved by 66.9% of the Audax shareholders; however, Cigna Health and Life Insurance Company, its minority shareholder, did not approve it. To receive their share of the merger consideration, non-signing shareholders were required to surrender their shares and execute a letter of transmittal. That letter of transmittal included a number of post-closing obligations that the signatory was bound by, such as a broad release of all claims against the buying parties that was not mentioned in the merger agreement and an agreement to be bound by the indemnification provisions in the merger agreement. Cigna did not want to sign that letter of transmittal, and the buyer refused to pay Cigna its share of the merger consideration. In response, Cigna sued the parties and challenged the letter of transmittal on several grounds, including that it violated Section 251 of the DGCL and, thus, was unenforceable, and the court agreed with Cigna.
The court held that, under Section 251 of the DGCL, once the merger was consummated, the shareholders' shares were immediately canceled and the shareholders were then entitled to receive their part of the merger consideration upon the surrender of canceled certificates. Conditioning receipt of the consideration on the acceptance of the release obligation in a letter of transmittal was interpreted to be an additional post-closing obligation that required separate consideration. Even though the letter of transmittal was mentioned in the merger agreement, the agreement did not provide that it would contain such a sweeping release as the shareholders later were required to accept. The court argued that to claim this release was part of the merger consideration would allow buyers to include all sorts of post-closing obligations in their letters of transmittal without ever mentioning them in the main merger agreement.
Additionally, the court held that the buyer could not obligate non-signing shareholders to accept the indemnification obligations requiring direct payment from them, because certain of the obligations were infinite in their duration and could potentially be equal to the entire amount of the consideration. Section 251 of the DGCL requires the merger consideration to be determinable, which in this case it was not because of the infinite possibility of an indemnification event occurring at any moment. The court noted, "[p]resumably, as time goes on, United [the buying party] will be less likely to assert a claim. Even then, however, the safety of the shareholders' money would remain uncertain. Two, five, or ten years after the closing, even accounting for laches or statute of limitations defenses, the shareholders largely remain in the same position as on the day of the Closing: potentially liable to United for up to the entire amount of the merger consideration they received."1 The court distinguished this from the post-closing price adjustments that are linked to the target's financial records because the financial records calculations are usually expressly set forth in the merger agreement, and they refer to some determinable numerical components. Here, even though the indemnification provisions were extensively described in the merger agreement, the uncertainty of their being triggered at any moment made it impossible to predict the amount of the consideration the shareholders were to receive.
Importantly, the court explicitly distinguished the indemnification obligations in this case from the escrow agreement structure that is frequently used. It stated that the decision does not address escrow agreements or the general validity of post-closing price adjustments, including the ones where there is either a time or a value limit. Moreover, the court emphasized that even though a party can agree to these obligations, they cannot be "foisted" on non-signing parties. Even though the holding was limited to the case's specific facts and circumstances, it raises some issues that buyers need to keep in mind in negotiating and effecting a merger involving non-signatory shareholders. Below are some considerations that might be helpful in that process.
- Consider structuring a deal as a stock purchase or, if a merger is still preferable, having each shareholder execute a joinder to a merger agreement and securing as many of them as possible prior to the closing.
- Avoid using letters of transmittal to impose any obligations on non-signing shareholders, as the Cigna case questions the enforceability of such obligations.
- If shareholders are bound by a shareholder agreement, carefully review its terms to see whether there are any drag-along provisions that would require shareholders to agree to provide indemnification in a transaction. If that is possible, consider advising the controlling shareholders to exercise those drag-along rights before the closing.
- If the consent of certain shareholders to certain post-closing obligations is crucial, condition the closing on their acceptance. Alternatively, if that acceptance is unlikely, consider requiring that signing shareholders be responsible for a larger share of indemnity obligations than their pro rata share.
- Include all post-closing shareholder obligations and releases in the merger agreement and ensure that consent solicitations distributed to shareholders disclose them in detail. Consider including such obligations in the consideration section of the merger agreement and stating that the purchase price is based on the expectation of their enforceability and that shareholders have to agree to these obligations in order to receive their share of the consideration.
- If shareholders are asked to provide a release or required to fulfill any other condition in a separate contract or letter to receive their share of the consideration, consider offering additional consideration. Alternatively, a merger agreement may mandate that a part of the purchase price consideration is withheld as a contingent right to additional consideration that can be paid upon the acceptance of the letter of transmittal.
- Escrow a part of the merger consideration to satisfy any post-closing indemnification claims, instead of potentially having them clawed back from the consideration that has already been paid. Additionally, consider requesting offset rights against any post-closing payments for deals with contingent consideration.
- Even if using an escrow, avoid setting indefinite survival periods for the indemnification obligations that allow recovery of the entire consideration from shareholders. Ideally, consider imposing both temporal and monetary limits on such obligations.
- Consider buying a representations and warranties insurance policy to cover any potential indemnification claims.
[1] Cigna Health and Life Ins. Co. v. Audax Health Solutions, Inc., et al, Del. Ch. Nov. 26, 2014.