Significant 2016 Decisions Affecting Private Company M&A
The following compilation is our third annual review of significant Delaware and New York court decisions relating to private M&A transactions and disputes. All decisions were issued in 2016 with the exception of In re Vaalco, which was issued at the end of 2015.
Hyatt v. Al Jazeera America Holdings II, LLC, 2016 WL 1301743 (Del. Ch. Mar. 31, 2016)
Buyers should beware of sellers' ability to recoup litigation costs incurred in defense of indemnity claims under D&O advancement provisions of merger agreement.
As described in our summer newsletter, this decision stemmed from Al Jazeera's acquisition of Current Media LLC. Joel Hyatt and Albert Gore, Jr. were both former members and directors, and Hyatt was a former officer, of Current Media. Hyatt also served as the Members' Representative under the merger agreement, with the responsibility for dealing with indemnification claims on behalf of the members of Current Media. After Al Jazeera had made a number of indemnity claims under the merger agreement, all of which Hyatt rejected, Hyatt and Gore initiated an action (the Underlying Action) in the Delaware Court of Chancery in their capacities as Members' Representative and member, respectively, contending that Al Jazeera's claim certificates were improper and in breach of the merger agreement, and seeking release of the indemnity escrow funds. Al Jazeera counterclaimed, alleging in part that Hyatt, as Members' Representative, had breached the merger agreement by wrongfully rejecting Al Jazeera's valid claims for indemnification, including those arising from breaches of representations and warranties under the merger agreement, which led to losses for Al Jazeera.
In an amended and supplemental complaint, Hyatt and Gore sought advancement of their litigation costs associated with defending the counterclaims in the Underlying Action, pursuant to D&O advancement provisions under the merger agreement. The merger agreement contained standard D&O indemnification and advancement provisions that obligated Al Jazeera to indemnify and advance fees and expenses to Current Media's former directors and officers, for a period of six years, to the same extent provided for under Current Media's Second Amended and Restated Operating Agreement (Operating Agreement). Hyatt and Gore conceded that their claims in the Underlying Action did not trigger advancement rights. However, they argued that Al Jazeera's counterclaims depended on Al Jazeera's contention that Hyatt and Gore, as directors and/or officers of Current Media, had caused the breaches of representations and warranties under the merger agreement. Hyatt and Gore argued that they had a financial interest in appearing and defending their actions as directors and/or officers, and it was this situation that triggered the D&O advancement rights under the merger agreement. Al Jazeera, on the other hand, argued that fee shifting provisions in the indemnification section of the merger agreement (obligating the nonprevailing party following a court judgment to pay the fees and expenses of the prevailing party) evidenced an intent by the parties to solely provide indemnification, and not D&O advancement, in any dispute relating to the indemnity escrow.
The court rejected Al Jazeera's argument that the fee shifting provision supplanted the D&O advancement provision because, according to the court, they involved different rights that served separate purposes. The court also rejected Al Jazeera's argument that advancement was not appropriate because Hyatt was sued in his capacity as Members' Representative and not as a former officer or director. The court held that Hyatt's rights in each capacity were preserved, noting that the parties could have, but chose not to, exempt Hyatt from the right to D&O advancement under the merger agreement.
The court then considered the scope of D&O advancement. The merger agreement entitled directors and officer to advancement to the extent they would have been entitled under the Operating Agreement. The Operating Agreement provided for mandatory indemnification in pending or threatened actions, suits or proceedings "by reason of the fact" that such person was an officer or director of Current Media, and indemnification included the right to advancement of reasonable expenses of the type entitled to be indemnified. Citing Homestore, Inc. v. Tafeen,1 the court equated "by reason of the fact" to there being a "nexus or causal connection" between the underlying proceedings and the defendant's "official corporate capacity." According to the court, this nexus exists if "corporate powers were used or necessary for the commission of the alleged misconduct," which does not require any allegation of breach of fiduciary duty. On the other hand, no nexus exists "when the parties are litigating a specific and personal contractual obligation that does not involve the exercise of judgment, discretion or decision-making authority on behalf of the corporation."
The court analyzed whether expenses could be advanced in connection with each of Al Jazeera's counterclaims. In finding that the requisite nexus existed with respect to Al Jazeera's indemnification claims alleging breaches by Current Media of various most-favored-nation provisions under contracts with third parties, the court wrote: "Although the Counterclaims appear on their face to merely implicate Hyatt's role as Members' Representative, the resolution of the validity of the [indemnification claims] in the Underlying Action, in part, necessarily requires Hyatt and Gore to defend their actions as former officers and directors, for which they are contractually entitled to advancement." On the other hand, the court found that Hyatt and Gore were not entitled to advancement with respect to a separate Al Jazeera claim that Current Media's former members agreed to indemnify Al Jazeera for 50 percent of the expenses it incurred with respect to termination of a specified agreement because that claim did not require Hyatt and Gore to defend actions taken in an officer or director capacity.
This decision serves as an important warning to buyers that D&O advancement provisions can be used by shareholders to circumvent their indemnification obligations under a merger agreement. Buyers who bring a court action to enforce an indemnification claim may find themselves in the position of funding the shareholders' litigation costs, which can, at a minimum, significantly alter the incentives and negotiating leverage in the litigation. Moreover, while the Al Jazeera decision focused on advancement rights, the logic could potentially be applicable in the context of D&O indemnification rights. This could potentially permit sellers to round-trip shareholder indemnification obligations under the merger agreement by claiming that they are indemnifiable losses for officers and directors under the merger agreement's D&O indemnification and advancement provisions.
Fortunately, the Al Jazeera court gave some clear guidance to buyers on how to address the risk. The court noted that the parties could have contractually exempted Hyatt from the right to D&O advancement under the merger agreement. Thus, the D&O indemnification and advancement section under the agreement could contain an exemption providing that such indemnification and advancement would not be available with respect to claims that relate to matters that are the subject of a buyer indemnification claim under the merger agreement. To be effective, the exemptive language should be included in both the merger agreement and any charter or other documents of the surviving corporation that contain D&O advancement and indemnification rights.
Read the ruling. Read our summer newsletter. 2. FdG Logistics LLC v. A&R Logistics Holdings, Inc., 131 A.3d 842, 845 (Del. Ch. Feb. 23, 2016), aff'd sub nom. 148 A.3d 1171 (Del. 2016)
In order to foreclose a claim for fraudulent inducement, a nonreliance clause in an acquisition agreement must set forth an affirmative expression of nonreliance by the buyer, and not merely a disclaimer by the seller of what the seller was or was not representing.
This case arose from the sale of a trucking company (Company) by affiliates of FdG Associates LP, a private equity fund (Seller), to an affiliate of A&R Logistics Holdings Inc., a transportation and logistics company (Buyer). Seller initiated the action in order to recover a preclosing tax refund. Buyer responded with counterclaims for indemnification, violation of the Delaware Securities Act, common law fraud and unilateral mistake. This summary focuses on Buyer's fraud claim, which was based on extra-contractual statements made to Buyer before it entered into the merger agreement. In denying Seller's motion to dismiss the fraud claim, the court held that the merger agreement did not contain an affirmative disclaimer of reliance by Buyer that was sufficient to preclude Buyer from asserting a fraud claim based on representations outside the four corners of the merger agreement.
Buyer's fraud counterclaims involved assertions that after the merger closed, Buyer discovered an extensive series of illegal and improper activities that were concealed from it during pre-merger due diligence. These activities included matters such as falsification by truck drivers of hours-of-service logs, manipulation of scale tickets and time stamps, environmental spills, falsely reporting regular maintenance as capital expenditures and fraudulently charging customers for washes that were not performed. In analyzing Buyer's claims, Chancellor Bouchard listed the following elements of a fraud claim under Delaware: "(1) the defendant falsely represented or omitted facts that the defendant had a duty to disclose; (2) the defendant knew or believed that the representation was false or made the representation with a reckless indifference to the truth; (3) the defendant intended to induce the plaintiff to act or...
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