A recent posttrial decision from Delaware regarding an alleged breach of a capitalization representation in a merger agreement is noteworthy. The decision establishes that a party is within its rights to back out of a deal even for seemingly nonmaterial breaches of representations and warranties that are not qualified by materiality. Whether there exists a right to terminate for a truly de minimis breach remains to be seen, however. The case also addresses other issues of interest to M&A practitioners, including enforcement of interim operating covenants and limitations on the customary covenant of the parties to use best efforts to consummate a transaction.
Background
In HControl Holdings v. Antin Infrastructure Partners, Chancellor Kathaleen McCormick of the Delaware Chancery Court agreed that Antin Infrastructure Partners S.A.S. and its affiliates (Buyers) were within their rights to terminate a merger agreement on account of a financially insignificant breach of a capitalization representation. Buyers, a private-equity firm with a great reputation in the market for deal certainty, had entered into a merger agreement to acquire a group of privately held broadband companies, collectively known as “OpticalTel,” which were founded by one Mario Bustamante. (Bustamante and the other owners of OpticalTel are referred to as “Sellers.”) The merger agreement contained a standard capitalization representation concerning the ownership of OpticalTel, accompanied by a bring-down provision requiring that the capitalization representation be “accurate in all respects” at the time of closing. Buyers claimed that Sellers had breached the capitalization representation, as a former employee of OpticalTel, Rafael Marquez, claimed that he owned an interest in one of the OpticalTel subsidiaries. Marquez’s interest did not appear in the schedule corresponding to the capitalization representation.
Marquez based his claim on a 2004 software agreement with the OpticalTel subsidiary HControl Corp. This agreement provided that Marquez, in consideration of the services he provided, would be paid $3,000 per month and “5% ownership of HControl Corporation to be distributed upon a liquidation event.” Bustamante testified that he never viewed the software agreement as conveying a form of equity interest to Marquez, but instead as requiring a cash payment to Marquez upon a liquidation event, such as the merger. Settlement efforts with Marquez failed since Marquez, a “seemingly colorful character and shakedown artist,” made unreasonable demands, claiming even to be a co-founder of OpticalTel.
Subsequently, in an attempt to redress the Marquez situation, Sellers implemented a “Transfer-Dissolution Plan.” Under this plan, Sellers transferred the software assets of the OpticalTel subsidiary in which Marquez claimed an interest to a parent company and then dissolved the subsidiary. Sellers placed in trust an amount believed to be sufficient to satisfy Marquez’s claims, and Bustamante provided a personal indemnity for any excess.
As is customary, the merger agreement included interim operating covenants requiring Sellers to operate the OpticalTel group in the “ordinary course of business” between signing and closing in all material respects, and to use commercially reasonable efforts to preserve intact in all material respects the present business organizations of the OpticalTel group. Buyers did not consent to the Transfer-Dissolution Plan and claimed that the plan violated the interim operating covenants.
After the parties failed to resolve their differences, Buyers terminated the merger agreement. Sellers then filed suit for specific performance and claimed that Buyers failed to use their contractually mandated best efforts to close the transaction.
The Court’s Decision
With Buyers’ debt commitment expiring on June 9, 2023, the court conducted a three-day trial in May 2023 and issued a posttrial decision at the end of May. The court conceded that it wrote its decision quickly and cut its editing process short, to permit potential appellate review before the debt commitment expired. The court found that Buyers were entitled to terminate the merger agreement based on the breached capitalization representation, although it rejected the claim that Sellers had violated other provisions of the merger agreement, including the interim operating covenants. It also found that Buyers had not violated their obligations under the best-efforts covenant of the merger agreement.
Sellers’ Breach of Capitalization Representation
The capitalization representation of the merger agreement extended to both “Equity Securities” and “phantom equity.” The court determined that Marquez’s interest was not an Equity Security, but held that Marquez’s interest did constitute unscheduled phantom equity. The court observed that the financial value of the Marquez claim was minor relative to the deal value, as Buyers conceded. It would almost certainly not have passed a materiality test. As opposed to other representations, however, the bring-down of the capitalization representation was not qualified by materiality and was required to be “true and correct in all respects.” Buyers resisted three attempts by Sellers to insert a materiality qualifier, and the representation lacked even a de minimis exception.
Without there being any sort of qualifying limitation to the capitalization representation, the court concluded that the representation had been breached and that the breach entitled Buyers to terminate the merger agreement. The court added that Buyers did have reason to be concerned with Marquez’s claims because of possible post-closing reputational harm. The extent to which this conjecture contributed to the court’s decision is unclear.
Sellers Did Not Breach Interim Operating Covenants
The court’s rejection of Buyers’ claim that Sellers’ Transfer-Dissolution Plan violated the interim operating covenants of the merger agreement is also instructive. The court observed that even after giving effect to the plan, the OpticalTel business continued to hold and enjoy the use of the critical software that Sellers had sought to put out of reach of Marquez’s claims. The software had simply moved to a different entity in the OpticalTel business group. The business continued to operate in the ordinary course, as a telecommunications company with long-term contracts to render services to communities in Florida.
Unlike the capitalization representation, the covenant to operate in the ordinary course did contain an “in all material respects” qualifier. The court observed, citing case law, that the “general purpose of an ordinary-course-of-business covenant is to ‘help ensure that the business the buyer is paying for at closing is essentially the same as the one it decided to buy at signing.’” Because the machinations of the Transfer-Dissolution Plan had no real effect on the availability to the business of the critical software, the court failed to see any material change in the business between signing and what would have been the closing.
Buyers’ claim that the plan violated the contractual requirement to maintain the present business organizations of the OpticalTel group fared no better. Citing case law, the court stated that “[p]reserving a business organization requires a company to maintain the operations and relationships inherent in a business structure. ‘Gutting’ a business organization does not satisfy the requirement to preserve it.” As neither the transfer of the software to a different entity in the group nor the dissolution of the entity that originally held the software altered the business of OpticalTel group, the group was hardly being gutted. Accordingly, the court held, Sellers did not fail to maintain intact the OpticalTel group in all material respects.
Buyers Did Not Violate Their ‘Best Efforts’ Obligation
Finally, the court concluded that Buyers had not breached the merger agreement by failing to use best efforts to close the deal.
The court offered some principles for analyzing compliance with a best-efforts covenant. A best-efforts clause, the court said, citing case law, “does not ‘require the identified outcome. Rather, it requires parties to try to achieve the identified outcome.’ Even a ‘best efforts’ obligation ‘is implicitly qualified by a reasonableness test — it cannot mean everything possible under the sun.’” Consistent with this reasonableness standard, the court stated that a “best-efforts provision does not require Buyers to sacrifice their negotiated contractual rights to solve a breach.” Buyers negotiated for a flat capitalization bring-down, which was not overridden by the best-efforts covenant.
The court was also persuaded that Buyers did not have “cold feet.” The court cited numerous indicia that Buyers were interested in the business even after the Marquez interest had been disclosed, although the last of these indicia was over a month before Buyers served their notice of termination. There is some implication that, notwithstanding the cited principles underlying the best-efforts covenant, buyer’s remorse could be a factor in determining whether enforcement of a breach might contravene best efforts.
Analysis and Takeaways
The HControl Holdings case is being cited for the proposition that even immaterial departures from representations that are brought down at closing without a materiality or de minimis qualifier will justify termination of a merger agreement. It is no doubt true that without a materiality qualifier, it will be much easier for a party to walk away from a deal on the basis of a financially insignificant breach. This takeaway needs to be tempered, however. It is hard to believe that the court would have allowed Buyers to terminate the transaction if the capitalization representation had been truly de minimis — say, if it were off by a share or two.
Moreover, there may have been other considerations contributing to the court’s decision. The court was persuaded that Buyers did not have remorse with respect to the business itself, and that there was at least some plausible breach-related reason for their decision to terminate. Buyers, the court found, did not want to be associated post-closing with Marquez’s dogged claims and the potentially attendant reputational harm. This leaves open the possibility that a court might set a higher walk-away bar when terminating for an immaterial breach of a flat representation was patently pretextual for the buyer’s unrelated business remorse.
It is worth observing that even with a materiality qualifier, a facially immaterial breach of a capitalization representation might get swept up in the bringdown. An undisclosed, otherwise insignificant interest in a subsidiary of the target could potentially constitute a material breach of a capitalization representation, where the acquirer does not have the ability to cash out the minority.
There is also something to be learned from the court’s other holdings. To serve as a basis for termination of a merger agreement, a breach of the interim operating covenants must have a cognizable effect on the business of the seller. The result of the breach must be such as to render the business materially different from the one the buyer thought at signing that it would be getting. This is not all that surprising, since these covenants are typically qualified by materiality, as they were in this case.
The court’s approach to the obligation of the parties to a merger agreement to use best efforts to close is also instructive. As has been the case in other contexts in Delaware, the court appended a standard of reasonableness to the parties’ best-efforts obligations, despite the absence of a statement of reasonableness in the contractual text. Of particular interest, however, is how the court approached the interplay between the best-efforts covenant and right of termination otherwise available to a party under the merger agreement. The court refused to read into the best-efforts covenant an obligation on the part of Buyers to work with Sellers to devise a work-around for the breach of the capitalization representation. But before drawing too broad a conclusion from the case in this regard, one must again take account of the court’s sense that Buyers did not simply have cold feet. The court might have held otherwise, and might have invoked the best-efforts covenant against Buyers, if it felt that Buyers simply lost interest in the business.
Had the court had more time to render its opinion in HControl Holdings, the contours of the decision might have been more precisely formulated. For now, there are certainly important conclusions to be drawn from the case, but perhaps without the last word having been spoken on the court’s holdings.
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