Cooley M&A Team News - January 2015

Cooley M&A Team News


Exploring the Scope of Recovery for Fraud Claims in Private Company Transactions
Court reviews detailed allegations and potential scope of recovery for fraud alleged against pre-closing officers, directors and, notably, innocent selling stockholders in a private company acquisition.

A Reminder on Adequate Process
The Delaware Chancery Court analyzes a dilutive recapitalization transaction under the entire fairness standard of review and finds flawed process, despite a fair price in the deal.

Is My Non-Binding Letter of Intent Actually Binding?
The Delaware Supreme Court rules that an integration clause in an acquisition agreement does not transform non-binding earnout provisions in a letter of intent into binding obligations under the definitive agreement.

Can We Talk? New York Court Broadens Common-Interest Privilege for Pre-Closing Communications
Aware that parties to an acquisition need to share legal advice in connection with pre-closing activities, a New York appellate court permits the common-interest privilege to protect pre-closing communication, even without pending or anticipated litigation.

M&A Releases and Post-Closing Indemnity Obligations in Private Company Merger Agreements
In Cigna Health & Life Insurance Company v. Audax Health Solutions, Inc. (Del. Ch. November 26, 2014), the Delaware Court of Chancery invalidated two buyer-imposed requirements that are frequently found in private company mergers.


Learning the Hard Way
HSR Gun Jumping—Lessons from Flakeboard/SierraPine

How to avoid illegal "gun jumping" in violation of the Hart-Scott-Rodino (HSR) Act and conduct rising to the level of a per se antitrust violation of the Sherman Act.


Nuts and Bolts of M&A Deals
Demystifying the Working Capital Adjustment


(includes pending transactions)

 Acompli acquired by Microsoft  Adaptive Path acquired by Capital One  Ambit acquired by Daiichi Sankyo  Aol acquisition of Vidible  Beachmint business combination with Lucky Magazine

Exploring the Scope of Recovery for Fraud Claims in Private Company Transactions

Great Hill Equity Partners IV, LP v. SIG Growth Equity Fund I, LLLP
(Del. Ch. Nov. 26, 2014) (denies defendants motion to dismiss fraud claims, analyzes scope of recovery for certain fraud claims in connection with a private company acquisition)

In a 2013 opinion in this case, the Court of Chancery held that the right to assert the privilege over attorney-client communications and ownership of such communications passes to the acquirer in acquisitions structured as mergers under Delaware law (read our summary of related matters).

Aided with additional information afforded by the prior ruling, plaintiff Great Hill Equity Partners (acquirer in the 2011 acquisition of Plimus, Inc.) amended its suit against former stockholders, officers and directors of Plimus, alleging that defendants intentionally withheld information regarding the deteriorating relationship of the target company's most significant commercial partners. Great Hill specifically made claims of fraudulent inducement, fraud, aiding and abetting, civil conspiracy, and, notably, with respect to former stockholders who were not alleged to have engaged in fraud, indemnification and unjust enrichment. As is often customary, the merger agreement in this deal provided that the escrow amount would serve as the sole recovery for indemnification, subject to fraud. Great Hill argued that if its fraud claims were successful, that it should also be able to seek indemnity from all former stockholders on a joint and several basis. In response, defendants took the position that the operative provision only served to permit tort recovery for fraud (beyond the terms of the contract), rather than indemnification from faultless stockholders. Similarly, the parties also took opposing positions regarding the ability to seek recovery for unjust enrichment against stockholders that did not participate in fraud. The Court declined to address either of these two claims in detail given the early stage of litigation in this case, noting that although ultimate recovery may only be for either a direct fraud or secondary participation in the fraud, there was no purpose to limiting plaintiffs' theory of recovery at this stage in the litigation.

For practitioners, the opinion offers a useful review of the application of current law to specific factual allegations of fraud (and a reminder of the leverage afforded by control of the attorney client privilege after a deal).

Read the full opinion

 Blackbird Technologies acquired by Raytheon Company  Broadsoft acquisition of Systems Design & Development  ChannelAdvisor acquisition of E-Tale  Draft Kings acquisition of StarStreet  Move acquired by News Corporation  Netscout acquisition of Danaher's communications business unit  Soverign Brands sale of Armand de Brignac to Jay Z  Volcano acquired by Royal Philips NV  Zorafi acquired by Yahoo

A Reminder on Adequate Process (Despite Fair Price): Delaware Court Addresses Breach of Fiduciary Duties in Dilutive Recapitalization Transaction

In re Nine Systems Corp. Shareholders Litigation
(Del. Ch. September 4, 2014) (application of entire fairness standard of review and determination of breach of breach of fiduciary duties in approving a transaction because it was the result of an unfair process, despite fair price)

This recent Court of Chancery decision highlights the emphasis Delaware courts place on transaction process generally and, regardless of a company's financial crisis or dwindling business alternatives, the requirement to discharge fiduciary duties by conducting a fair process regardless of fair transaction price.

For practitioners who regularly work with privately financed companies, the In re Nine Systems fact pattern is a familiar one. In 2002, faced with the prospect of winding down, the company board approved a recapitalization of the company that provided for (i) an investment of additional capital from two of its three existing majority equity holders and (ii) significant dilution of minority, non-participating stockholders. The five member board approving the transaction consisted of the company CEO and three designees of the existing investors who, together, owned more 54% of company equity and 90% of company debt. The stockholder vote approving the transaction was obtained only from equity holders "around the table." The board did not obtain an independent valuation of the company prior to the recap or perform its own collective analysis; it did, however, accept a $4 million "back of the envelop" valuation developed by one of the investor's principals.

Four years later the company was sold for $175 million and minority stockholders brought suit to challenge the 2002 recap. Similar to the Court of Chancery's 2013 decision in In re Trados Shareholder Litigation (read our prior summary), the Court held that the $4 million valuation used for the recap transaction was fair because, at the time, the Company's equity was worth zero. In contrast to In re Trados, however, the Court in In re Nine Systems took one step further in its review of fiduciary duties under the entire fairness standard—it found the process employed for the review and approval of the recap unfair, despite a finding of fair price. In particular, the court noted the following board process failures: (i) refusal to hire an independent financial advisor; (ii) failure to be informed or involved in the $4 million valuation determination; (iii) refusal to obtain input or approval from the board's sole independent director (who opposed the transaction); (iv) the choice not to obtain the separate vote of minority stockholders; and (v) materially deficient disclosure to stockholders following approval of the transaction. Although the Court declined to award money damages in the case, it did permit plaintiffs to seek attorneys' fees and costs (while noting that a remedy for unfair process in this context could include a determination and award of a "fairer" price).

In particular, practitioners should note the Court's clear statement that In re Trados should not be interpreted as a "broad proposition that a finding of fair price, where a company's common stock had no value, forecloses a conclusion that the transaction was not entirely fair. Rather, the Trados conclusion reinforces the defining principle of entire fairness—that a court's conclusion is contextual." While the court made it clear that independent valuation opinions are not per se required in order to avoid entire fairness review in a context such as In re Nine Systems, companies faced with dilutive or similar extraordinary corporate transactions should work closely with counsel to ensure all appropriate process measures are in place prior to corporate action. Particular attention should be paid to the voice and approval of independent directors and the recognition of duties to all company stockholders (including minority and common stockholders). This can be complicated for venture-backed companies with limited budgets, but because the In re Nine Systems Court found the venture capital investors to comprise a control group with fiduciary duties (or, alternatively, potentially liable for aiding and abetting director's breaches of their duties), boards will need to think tactically about these matters on a go forward basis.

Read the full opinion


Read prior editions of Cooley M&A Team News

September 2014

June 2014

March 2014

January 2014

December 2013

October 2013

Is My Non-Binding Letter of Intent Actually Binding?

ev3, Inc. v. Lesh
(Del. Sept 30, 2014) (addressing the impact of an acquisition agreement integration clause on provisions of a non-binding letter of intent previously executed by the parties)

The Delaware Supreme Court recently overturned a $250 million jury verdict that centered on contractual interpretation of an "integration clause" in a definitive acquisition agreement, as applied to provisions of the related letter of intent previously executed by the transaction parties. In ev3, Inc. v. Lesh, the Supreme Court ruled that an integration clause in an acquisition agreement does not transform non-binding provisions of a letter of intent into subsequently binding provisions. Accordingly, only those provisions in the letter of intent specified as binding (and surviving) will continue as operative provisions in connection with any integration clause.

Appriva was acquired by ev3 in 2002 for $50 million plus up to $175 million in contingent milestone payments. Shortly after the acquisition, ev3 made the determination that Appriva's technology no longer appeared promising and ceased funding related development. Appriva's stockholder representative sued, claiming that milestone payments should be paid in full following ev3's alleged breach of (i) obligations in the acquisition agreement to fund and pursue regulatory milestones in ev3's "sole discretion, to be exercised in good faith" and (ii) a non-binding provision in the previously executed letter of intent in which ev3 stated that it would commit to funding development and ensure sufficient capital to achieve the performance milestones. With respect to the second claim, Appriva relied on the integration clause in the acquisition agreement which provided that it contained the entire understanding among the parties and superseded all other agreements or understandings among the parties except for the letter of intent. As is typical, the letter of intent contained a provision delineating certain provisions as binding (e.g., confidentiality, exclusivity and transferability) and all others as non-binding.

With respect to the power of the integration clause, the Supreme Court held that only the provisions specified as binding (and surviving) would be operative pursuant to the acquisition agreement "integration clause." Put simply, the integration clause in the acquisition agreement did not convert the previously non-binding funding provision of the letter of intent into a binding obligation. As the Court noted, "survival [of a provision] is not transformational." The court also found that the lead in language to the milestone covenant in the acquisition agreement—"notwithstanding any other provision in the Agreement to the contrary"—rendered any contrary provision (i.e., the letter of intent funding provision) ineffective. As the covenant made it clear that funding was in ev3's sole discretion, any contrary position in the letter of intent was superseded by the operative provisions of the acquisition agreement.

Going forward, parties to acquisitions with contingent consideration should ensure that covenants regarding earnout or milestone efforts are carefully and specifically drafted. No party should rely on non-binding provisions of a letter of intent. It's what's in the definitive acquisition agreement that counts!

Read our related summary of "good faith" covenants for earnouts

Read the full opinion


Can we Talk? New York Court Broadens Common-Interest Privilege for Pre-Closing Communications

Ambac Assurance Corp. v. Countrywide Home Loans, Inc., No. 651612/10
(N.Y. App. Div. 1st Dep't Dec. 4, 2014) (common-interest privilege applied to acquisition parties' pre-closing communications even without related pending or anticipated litigation).

Historically, New York courts took a narrow view of the common-interest doctrine—permitting third parties to share in attorney/client communications without destroying confidentiality privilege only with respect to communications in pending or reasonably anticipated litigation. Recognizing that parties to a deal often must share legal advice regarding key interests prior to consummating a transaction, the New York Appellate Court held that pending or reasonably anticipated litigation was not a necessary element of the common-interest privilege. The purpose of furthering a legal interest or strategy common to the parties is sufficient for application of the doctrine in New York (similar to the approach applied in many federal courts and Delaware state court). Specifically, the Court held that "two business entities, having signed a merger agreement without contemplating litigation, and having signed a confidentiality agreement, required the shared advice of counsel in order to accurately navigate the complex legal and regulatory process involved in completing the transaction."

Read the full opinion


M&A Releases and Post-Closing Indemnity Obligations in Private Company Merger Agreements

In Cigna Health & Life Insurance Company v. Audax Health Solutions, Inc. (Del. Ch. November 26, 2014), the Delaware Court of Chancery invalidated two buyer-imposed requirements that are frequently found in private company mergers, specifically the conditioning of payment of merger consideration on a release and certain aspects of post-closing stockholder indemnity obligations. The case arose from United Health Group's acquisition of Audax Health by merger. As part of the merger, the former stockholders of Audax Health were required, as a condition to receipt of their portion of the merger consideration, to sign a letter of transmittal that contained a release and an acknowledgment of the indemnification provisions of the merger agreement. Cigna, one of the former stockholders of Audax Health, refused to sign the release or acknowledge the indemnification obligations. In a relatively limited ruling, the Court, first, invalidated the requirement that Cigna enter into a release as a condition to its receipt of merger consideration. The Court found that the release requirement lacked consideration. While noting that the release in the context of the transaction was very broadly written, the Court based its holding on the fact that the release was an after-imposed condition and invalidated it principally because the merger agreement, itself, did not specifically reference the release as a condition of payment. The Court, next, invalidated the requirement in the merger agreement that Cigna acknowledge the indemnification obligations. The Court's holding with respect to the indemnity acknowledgment was also limited and based on the fact that the indemnification provision exposed Cigna to a clawback of its entire merger consideration for breaches of certain fundamental representations for an indefinite period of time. The Court did not decide whether a more limited formulation would be permissible. The transaction did not include an escrow provision and the Court acknowledged that escrows are commonly used in acquisitions and that the ruling did not invalidate the use of escrows of a portion of merger consideration.

Impact of the opinion on private M&A practice

Due to the limited nature of the ruling, we do not expect the decision to materially impact private company mergers and acquisitions practice. Transaction planners, however, should be aware of the opinion and should be cognizant that the opinion may influence market practice in the following areas:

Joinders; post-closing indemnification obligations and purchase price adjustments. The most difficult aspect of the Cigna decision to assess is its impact on structuring post-closing purchase price adjustments and post-closing indemnification obligations. We do not believe that the decision should be read to necessarily require the separate agreement of individual stockholders for them to be bound by escrows or working capital or similar price adjustment mechanisms in all cases. However, the decision does call into question any post-closing indemnification provision in a merger agreement that purports to bind non-signatories to indemnification obligations that are uncapped (or that are capped at a stockholder's pro rata share of the full merger consideration), whether or not limited to fundamental representations, for an indefinite period of time. At the same time, the decision suggests that post-closing indemnification obligations that survive for a fixed term of a reasonable duration are generally permissible. Although the Court did not draw a definitive line, it did specifically say that its decision to allow Cigna to tender its shares for merger consideration free of indemnification obligations only applied to those aspects of the indemnification obligations that were not subject to a monetary cap and a time limit of 36 months or less. In the future, we expect that transaction planners may consider mitigating enforceability risk by requiring written joinder or other agreements from a supermajority (such as 90%+) of the stockholders of the target, deferring (or holding back a larger portion of the consideration) or otherwise taking steps to make the merger agreement look more like a stock purchase agreement (see above). These mitigation techniques were used actively in private mergers and acquisitions practice prior to the ruling and we would expect them to continue to be used, perhaps with greater emphasis, after the ruling.

Stockholder releases. We do not expect the Court's decision regarding stockholder releases to dramatically impact practice because many practitioners were already somewhat skeptical about the enforceability of releases in letters of transmittal. To the extent that receipt of releases are critical in particular transactions, the merger agreement should clearly indicate that the delivery of releases from a specified list or category of stockholders will be a condition to closing and will be a requirement for the payment of the merger consideration. As an additional "fix," however, and to improve the likelihood that a court would approve a release requirement in any particular instance, transaction planners should also consider narrowing the scope of the requested stockholder release by, perhaps, limiting the release to cover only stockholder-related claims or paying separate consideration for the release.

Transactions structured as stock purchases instead of mergers. We anticipate that some more risk adverse buyers will read the opinion broadly and insist on structuring deals as stock purchase transactions instead of mergers, and thereby requiring 100% stockholder unanimity before agreeing to move forward with a transaction. We do not think this is a practical approach in many transactions with numerous stockholders or with former employees/founders as stockholders and would not generally recommend that our buy side clients take this approach. To the extent that a trend towards stock purchases emerges from this decision, we would hope (and expect) that it would be limited, and that a relatively few number of buyers will adopt it as a uniform requirement. The costs to transaction participants—in terms of lost flexibility in transaction planning and the potential for one or a few minority stockholders to hold the others hostage—seem to us to be too great otherwise.

Impact of the opinion on corporate venture

One less talked about aspect of the Cigna case may be the impact that the case has on corporate venture investment. In this case, Cigna's assessment of the release it was asked to sign was undoubtedly colored by the fact that the acquirer in the transaction, an affiliate of United Health Group, was one of Cigna's biggest competitors. We will be curious to see if the facts of the case have the effect of discouraging promising companies with other alternatives from raising private capital from strategic investors in the future.


Learning the Hard Way
HSR Gun Jumping: Lessons from Flakeboard/SierraPine

Given the many opportunities and challenges that come from integrating two companies following a strategic transaction, including unlocking significant synergies and cost savings as a result of the combination, it is unsurprising that merging parties are often enthusiastic about moving forward with the process as soon as possible. Equally, it is natural that an acquiring party may be eager to maintain the value of the transaction that it bargained for. However, engaging in pre-merger coordination—prematurely transferring control or integrating business operations before the proper antitrust hurdles are cleared—in furtherance of these objectives can have dire consequences, both for the proposed merger itself and for the would-be merging parties.

Case in point—see DOJ's recent enforcement action against Flakeboard and SierraPine, following the abandonment of their proposed deal. Several weeks after the parties announced that they were walking away from their proposed transaction in the face of serious DOJ antitrust concerns, the DOJ alleged that during the pendency of its investigation, both parties had engaged in illegal "gun jumping" in violation of the Hart-Scott-Rodino (HSR) Act and illegal conduct that rose to the level of a per se antitrust violation of the Sherman Act.

The parties agreed to settle DOJ's allegations through a Consent Settlement, under which Flakeboard and SierraPine each agreed to pay $1.9 million in civil penalties for "jumping the gun." Even more extraordinary, the settlement requires Flakeboard to disgorge $1.15 million in "ill-gotten gains," the approximate amount of profits that Flakeboard allegedly obtained by illegally coordinating with SierraPine, marking only the second time that the DOJ has demanded disgorgement as a remedy.

Overview of applicable laws and penalties

Under the HSR Act, parties must not transfer control of the target's operations or consummate their transaction until expiration of a mandatory waiting period. The Sherman Act prohibits agreements between competitors to reduce output and/or allocate customers (among other things). Importantly, merging parties must be mindful that the Sherman Act applies to the conduct of the parties during the period prior to closing, just as it would apply to competitors in the absence of a proposed transaction.

Civil penalties for gun jumping can be substantial, with maximum fines up to $16,000 for each day in violation, which can be applied to both the buyer and the seller. Separate penalties for a violation of the Sherman Act are also significant, including behavioral injunctive relief as well as potential disgorgement of illegally obtained profits.

Pre-merger conduct gone wrong

Flakeboard and Sierra are manufacturers of several varieties of particleboard and medium density fiberboard. In January 2014, Flakeboard announced its intention to acquire three Sierra mills, and filed the required notifications under the HSR Act. Shortly after the announcement of the transaction, a labor dispute arose at one of the Sierra mills, located in Springfield, Oregon. The transaction agreement contemplated that Sierra would shutter the Springfield mill before closing the transaction, but only after the expiration of the HSR waiting period; a plan which changed following the labor dispute.

Sierra allegedly consulted with Flakeboard regarding how it should deal with the labor dispute, and ultimately reached an illegal agreement with Flakeboard that involved Sierra closing the Springfield mill within a matter of weeks (during the pendency of the DOJ's review under the HSR Act) and transferring the mill's customers to a nearby Flakeboard mill following the closure. Specific alleged coordinated conduct that culminated in the transgression included:

  • Agreeing on the content of a press release, and timing the release to give Flakeboard an opportunity to reach out to affected Sierra customers in advance of the press release.
  • Sierra told affected customers that Flakeboard would match all current Sierra prices.
  • Sierra supplied Flakeboard's sales force with competitively sensitive customer information such as contact details and volumes purchased.
  • Sierra did not try to retain business by transitioning any customers to one of its other mills, and instead directed business to Flakeboard.
  • Sierra relayed messages from Flakeboard to key employees that they should direct business to Flakeboard, along with assurances of future employment.

The DOJ viewed these coordinated activities as not reasonably necessary to the underlying transaction and that they were taken without any assurance that the transaction would ultimately be consummated, thereby condemning this conduct as per se unlawful under the antitrust laws, as well as a gun jumping violation under the HSR Act. Notably, had Sierra made its own unilateral decision to close the Springfield mill early, without taking the coordinated actions outlined above, this enforcement action may have been avoided altogether.

Not just the money

Successful advocacy before the DOJ or FTC is, in many cases, what makes the difference between a transaction that clears relatively quickly and efficiently and one that draws an expensive, time-consuming, and distracting investigation and/or a potentially deal-killing challenge by antitrust enforcers. Consequently, the risks of gun jumping include not only millions in civil fines, and the potential for disgorgement, but also the souring of the parties' relationship with the same government attorneys whom they are trying to persuade that the transaction does not raise serious antitrust concerns.

Avoiding perils—staying safe

Due diligence and integration planning are vital to ensure that the combined business is ready to hit the ground running on Day One following consummation of the transaction. As the Flakeboard case vividly illustrates, parties need to be careful not to stray from what is reasonably necessary to achieve this goal, and consult counsel to avoid the potentially dire consequences of gun jumping allegations.

While some cases are clear, most gun jumping issues are extremely fact-specific—employees, officers, and directors should be encouraged to contact counsel if there is any doubt at all as to whether a contemplated communication or action is permissible.

Related Contacts
Barbara Borden Partner, San Diego
Jamie Leigh Partner, San Francisco
Related Practices & Industries

Mergers & Acquisitions