When M&A transactions end in post-closing disputes, the right to assert privilege with respect to communications that the acquired business conducted with its counsel pre-closing can be of critical importance and possibly outcome determinative. A buyer would very much like to have access to those communications, while the seller would naturally like to shield the communications from the buyer’s prying eyes.

The Delaware Court of Chancery addressed this issue last year in DLO Enterprises, Inc. v. Innovative Chemical Products Group, LLC (Del. Ch. June 1, 2020), analyzing in a letter ruling the privilege and its waiver in a dispute between parties to an asset purchase agreement. The court affirmed the default rules that sellers retain the privilege in asset deals, while purchasers succeed to the privilege in merger transactions. These rules can be altered, however, either contractually or through the post-closing conduct of the parties.

The Case

In early 2018, Innovative Chemical Products Group LLC purchased substantially all the assets of Arizona Polymer Flooring, a company that developed and sold adhesive products. As part of the transaction, certain shareholders of the seller assumed employment positions with the buyer. After the transaction closed, the buyer claimed to have discovered that one of the seller’s product lines suffered from defects. The buyer sued, and alleged that the seller knew of the defects and knowingly misrepresented that its financial statements contained no undisclosed liabilities.

During discovery, the seller withheld certain communications with its lawyer on the basis of privilege, including:

• Deal-related attorney-client communications that remained in the seller’s possession (referred to by the court as Category 1 Documents)
• Communications before and after closing of the transaction between shareholders of the seller who entered the employment of the buyer and the seller’s deal counsel, through email accounts transferred to the buyer at closing (referred to by the court as Category 2 Documents)

The Category 1 Documents

Section 259 of the Delaware General Corporation Law (DGCL) provides that “all property, rights, privileges, powers and franchises” of the parties to a merger become “the property of the surviving or resulting corporation.” On the basis of this section, the court reasoned that, absent an express carve-out in the merger agreement, in a merger transaction, “the privilege over all pre-merger communications — including those relating to the negotiation of the merger itself — [passes] to the surviving corporation in the merger.” (Although not addressed by the court, the privilege should inure to the buyer in a stock purchase transaction as well, since one would expect it to travel with the corporate enterprise.)

However, the court observed, this is not the case with asset purchases. No statute provides for the transfer of privilege over all pre-closing communications in an asset sale. According to the court, such a sweeping rule would make little sense, given that the seller often remains a going concern and needs the privilege to help “prosecute ... and defend” claims concerning retained assets. In an asset purchase, the default rule is that the selling entity, at a minimum, retains the privilege over its pre-closing communications about retained assets and liabilities, and about the transaction itself.

The court acknowledged that parties to an asset purchase could modify the default privilege allocation by agreement. In the DLO Enterprises case, the transaction agreement gave the buyer the right to waive privilege over communications concerning “purchased assets and assumed liabilities.” The buyer argued that this provision effectively afforded the buyer the right to waive privilege in its favor, overriding the default rule. The court rejected the buyer’s argument. Reasoning that because “the [seller’s] rights under or pursuant to [the] Agreement” constituted “excluded assets,” the buyer’s right to waive privilege regarding the purchased assets did not extend to pre-closing deal communications.

The Category 2 Documents

Category 2 Documents consisted of communications through emails in accounts that had been transferred to the buyer as part of the asset purchase transaction, including emails that had been exchanged both pre- and post-closing. The court requested additional briefing to determine whether privilege had been waived regarding those communications. The court suggested, however, that the “inadvertent production” standard could apply to the pre-closing emails, which would protect them from disclosure.

The post-closing emails were another matter, as they were created after the communicating seller shareholders had begun working for the buyer. The court applied the employee-expectation-of-privacy test to these emails, whose elements include whether the employer has a policy of banning personal email use; whether the employer monitors employees’ computers or email; whether any third parties have a right to access employees’ computers or emails; and whether the employer notified the employees (or the employees otherwise knew) of the employer’s use and monitoring policies. While inclined to rule for the buyer regarding these communications, the court reserved judgment and requested additional briefing.

Takeaways

Because access to attorney-client communications between a seller and its counsel can be outcome critical to post-closing dispute resolution, parties to M&A transactions should give considered attention in their documentation to the ownership of the attorney-client privilege after the deal closes. The default rules in Delaware provide that the buyer inherits the privilege in a merger transaction, and likely in a stock purchase transaction, while the seller retains the privilege in an asset deal, but careless or inattentive drafting could unintentionally override these rules. Also, a selling party would ordinarily not want to lose control of the privilege over pre-closing communications with its counsel, whether the transaction is structured as a merger or as an asset deal.

Parties are therefore advised to specifically address the ownership of the pre-closing attorney-client and work product privileges in their transaction documentation, and assure that these allocation provisions are applied notwithstanding any inferences that could be drawn from other sections of the purchase agreement. Sellers, in particular, will want to be very precise concerning their retention of the privilege in respect of the transaction itself, regardless of the form the transaction assumes. Buyers, on the other hand, will want to assume control of the privilege to the extent it pertains to actions that do not involve disputes between the parties, and should assure that the documentation gives them the right to do so.

The DLO Enterprises ruling is also a cautionary tale on how privilege can be lost in a world in which so much of attorney-client interaction is conducted and recorded in informal communication through electronic media. Where a seller’s email accounts are transferred to a buyer — either as a matter of law in a merger or as an “included asset” in an asset transaction — the seller should be careful to scrub those accounts for privileged communications prior to closing. In the not-uncommon situation in which mission-critical shareholders of a seller agree to post-closing employment with the buyer, those shareholders must take appropriate steps after the deal closes to guard communications with their transactional counsel. Shareholders who use the email systems of their new employer to do so are inviting possible waiver of the attorney-client privilege.

Conclusion

Issues of attorney-client privilege in M&A transactional documentation tend to fall into the category of boilerplate, which often gets scant attention from the parties as they focus on the far more engrossing economic issues of the deal. As the DLO Enterprises ruling demonstrates, however, this boilerplate can itself have material economic consequences if disputes arise between the parties post-closing. Attention to allocation of privilege during the drafting process is another one of those instances in which an ounce of prevention can be worth many pounds of cure during a post-closing litigation.

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