A Summary of HControl Holdings LLC, et al. v. Antin Infrastructure Partners.

Defined terms are the battlefield for lawyers. Some terms are well trodden, while others are not. A recent case in the Delaware Court of Chancery underscores that even ostensibly innocuous terms can pack a punch. On May 29, 2023, the Delaware Court of Chancery decided HControl Holdings LLC, et al. v. Antin Infrastructure Partners SAS., et al. Antin Infrastructure Partners S.A.S. (Antin or Buyers), a French private-equity firm founded in 2007 that solely invests in infrastructure, entered into a merger agreement (the Merger Agreement) with a group of broadband companies collectively referred to as OpticalTel (the Company or Sellers). Following the signing of the Merger Agreement, it was discovered that a former employee of OpticalTel held phantom equity in one of Sellers’ subsidiaries. When Buyers terminated the Merger Agreement due to Sellers’ alleged breach of their capitalization representations, the construction of the capitalization representations, with a central focus on what is meant by equity securities and phantom equity, became the heart of this case.

Drafting of the Capitalization Representations

The Memorandum Opinion (the Opinion), published by the Court of Chancery of the State of Delaware (Court) and authored by the Honorable Chancellor Kathaleen St. J. McCormick, dives into the process of drafting the Merger Agreement between Greenberg Traurig (Greenberg), as counsel to Buyers, and Latham & Watkins (Latham), as counsel to Sellers. In response to Latham’s draft of the Merger Agreement, Greenberg provided edits to Section 4.02 of the Merger Agreement, the “Capitalization Representations,” and Section 7.01(a), the “Fundamental Representations.” Greenberg’s markup incorporated “Equity Securities” as a defined term.¹ The references now stated, respectively, “[t]he Units constitute the only outstanding Equity Securities of the Purchased Entities” and “[a]ll of the Equity Securities of each of the Subsidiaries of the Purchased Entities are wholly-owned by the applicable Purchased Entity or one of the applicable Purchased Entity’s Subsidiaries.”

The remainder of the Capitalization Representations remained the same and stated, “[t]here are no outstanding . . . phantom equity, . . . or other similar rights, agreements, arrangements, undertakings or commitments of any kind to which any such member of the Company Group is a party obligating it to . . . grant, extend or enter into any . . . phantom stock.” The Court points out in its opinion that this language extends the scope of the Capitalization Representations to include not just the defined Equity Securities but also phantom equity and similar ownership rights.

A subsequent edit by Buyers additionally removed Sellers’ de minimis qualification from the bring-down provision of the Merger Agreement. The Merger Agreement’s language became relevant to the case at hand when several former employees of OpticalTel began asserting rights to the ownership of OpticalTel and its subsidiaries.

Background

OpticalTel was formed in 2003 and was set up as four top-level LLCs; namely, HControl Holdings LLC, OTI Fiber LLC, Rural Broadband Systems, LLC, and Community Fiber LLC. HControl Holdings held three operating entities: HControl Corporation, Optical Telecommunications, Inc., and Community Services LLC. Rafael Marquez was a coder who was engaged by the then-CEO of OpticalTel, Mario Bustamante, during the infancy of OpticalTel to assist in implementing the software that Bustamante had previously designed. Bustamante and Marquez entered into a Software Development Agreement (Software Agreement) containing the deferred compensation arrangement that became the subject of this litigation. The “Fee and Other Compensation” arrangement of the Software Agreement stated:

In consideration of the services to be performed during the term of this Agreement, HControl shall pay to the Consultant:

• $3,000 per month payable on the 15th and 30th day of each month.
• 5% ownership of HControl Corporation to be distributed upon a liquidation event.

Marquez continued working with OpticalTel until 2016. Notably, Marquez was never treated as an equity owner by the Company, having never received a K-1 tax form or voted as a shareholder.

On December 3, 2022, Buyers and Sellers entered into the Merger Agreement, which included a base purchase price of $230 million and up to $30 million in additional earnout compensation. In late December 2022, when the OpticalTel-Antin deal was publicly announced, Marquez reached out to Bustamante stating he was entitled to 5% ownership of the entire OpticalTel company group, rather than just HControl Corporation. According to Bustamante’s accounts of the events, Marquez became increasingly hostile with his demands. On January 6, 2023, Sellers notified Buyers of the ongoing dispute with Marquez.

As the issue progressed, Bustamante prepared summaries of the Company’s arrangement with Marquez, and these summaries were provided to counsel on both sides of the transaction. The summaries included descriptions of Marquez’s rights, stating Marquez had a right to “5% of any net proceeds made from licensing fees on the software or from a liquidity event in respect of HControl Corporation” and “[Marquez] would be treated as a 5% owner, meaning he would get 5% of the profit.” Marquez engaged counsel on his behalf and began making claims for amounts far exceeding OpticalTel’s expectations (in its later settlement offers, it valuated HControl Corporation at $9.5 million) and even claimed to be the owner of the Company’s software. Sellers’ and Buyers’ counsels began consulting each other on the potential exposure and delineating a path to resolve the dispute with Marquez. Sellers put forth several settlement offers that were proposed to Marquez, including a $300,000 payment. Marquez refused all settlement offers. As an additional effort to address Marquez’s claim, Sellers initiated a transfer-dissolution plan that transferred HControl Corporation’s software to HControl Holdings for an amount of $4.3 million, consistent with the fair market value of the software. There was $215,000 set aside into a trust for Marquez’s claims. Following the transfer, Sellers filed dissolution papers in the state of Florida for HControl Corporation.

With hopes of a settlement thwarted, the relation between Buyers and Sellers, and their respective advisors deteriorated. In February 2023, another former OpticalTel employee, Wajid Iqbal, stepped forward claiming a similar ownership right. Iqbal claimed Bustamante had, in an arrangement similar to Marquez’s arrangement, promised him a 5% ownership interest in OTI Fiber through an oral agreement. Iqbal also had received warrants and been promised options by the HControl Holdings board. Iqbal was approached to settle his claims but rejected the Company’s offer of $55,000.

Antin and its advisors were upset at the Company’s efforts to resolve these issues and became increasingly concerned by the exposure Marquez and Iqbal posed to OpticalTel. By February 6, 2023, Buyers sent their first notice of breach to Sellers under the Merger Agreement, alleging Sellers’ breach of the Capitalization Representations. When Sellers made efforts to right the issue through their transfer-dissolution strategy, Buyers remained unconvinced that the breach of the Capitalization Representations was resolved and submitted a second notice of breach to Sellers. Finally, on March 8, 2023, Buyers sent Sellers a notification of termination of the Merger Agreement due to Sellers’ alleged failure to cure breach of the Capitalization Representations.

In anticipation of the March 8 notice, Sellers filed this action in Delaware Court on March 6, requesting Buyers’ specific performance.

Legal Analysis

After an expedited trial, the Court held for Buyers. Buyers claimed, among other violations, that Sellers breached the Capitalization Representations because (a) Marquez and Iqbal owned interest that fell under the Capitalization Representations, and (b) Sellers failed to cure their breach of the Capitalization Representations. The Court noted that, if the Capitalization Representations were not “true and correct in all respects” (emphasis added by the Court), then Sellers’ failure to cure the breach(es) allowed Buyers to validly terminate the Merger Agreement under its terms. Buyers argued that Marquez owned Equities Securities or phantom equity, and Iqbal owned Equity Securities within the meaning of the term in the Merger Agreement.

Both Sellers and Buyers, “rather humorously,” as the Court pointed out, argued that the interpretation of the terms of the [Software Agreement] was unambiguous. Buyers based their interpretation upon the verbiage “ownership,” which is an indication that the individual is entitled to Equity Securities in line with the percentage accompanying such a reference. However, the Court, siding with Sellers’ interpretation, determined that the “5% ownership of HControl Corporation” to which Marquez was entitled at liquidation of HControl Corporation is a “contingent value right” (CVR). A CVR is “a right that triggers payment upon a defined event such as an M&A transaction or a type of liquidation.” Estimating the intent of the parties in entering into the Software Agreement, the Court stated that the language of the Software Agreement, by a preponderance of the evidence, gives Marquez a CVR in the form of “a right to a cash payment upon a liquidation event in the amount of 5% of the value of HControl Corporation.” In agreeing with Sellers’ claim that the Software Agreement granted Marquez a right to payment upon a liquidation event, the Court noted that while words like “grant” or “issue” describe conferring equity, the words “shall pay” typically refer to cash payment.

With this in mind, the Court turned its focus to whether a CVR falls under the definition of phantom equity. As the Court put it, “the term phantom equity comes to Buyers’ rescue.” Colloquially, the Court referred to phantom equity as “an unsecured contractual right that takes on economic characteristics of employer’s equity.” Citing Black’s Law Dictionary, the Court provided the following definition of a “phantom stock plan”: a “long-term benefit plan under which a corporate employee is given units having the same characteristics as the employer’s stock shares. It is termed a ‘phantom’ plan because the employee doesn’t actually hold any shares but instead holds the right to value those shares.” Sellers claimed that the Software Agreement does not have the attributes of stock since there are no dividends or voting rights that coincide with Marquez’s compensation under the Software Agreement. The Court, being uncompelled by Seller’s argument, determined that the “5% ownership” interest in the Software Agreement is phantom equity. The Court pointed out that Sellers’ definition was generally describing equity, but “just like ghosts are not people, phantom equity is not equity.”

With this in mind, the Capitalization Representations within the Merger Agreement, as negotiated — removing the de minimis qualifier and revising the definition of Equity Securities — were not “true in all respects,” and Buyers successfully proved that Sellers were in breach of such representations. Accordingly, the Court ruled in Buyers’ favor and agreed it was within Buyers’ right to terminate the Merger Agreement.

Conclusions & Takeaways

(a) Contract Drafting

To the extent that a party wishes to expand the definition of Equity Securities to include phantom equity, it will need to proactively add to the definition of Equity Securities in order for a Court, under its principles of contractual construction, to consider phantom equity within the meaning of equity. Typically, though, as is the case here, capitalization representations in transaction agreements will explicitly require disclosure of any phantom securities, even if the definition of Equity Securities does not explicitly capture phantom arrangements. Accordingly, sellers should be mindful of any requirement to disclose such arrangements, notwithstanding the definition of Equity Securities.

(b) De Minimis and Materiality Qualifiers

In this case, Buyers conceded that the claims at issue were minor in the context of the total value of the transaction. However, because the representations in this case were stripped of de minimis or materiality qualifiers, it remains an open question whether the Court would have decided this case differently had the representations at issue been brought down subject to such qualifiers. Nonetheless, phantom equity arrangements often provide significant value to holders, so parties to any transaction should be diligent in their review of all relevant materials to ensure no such arrangements exist.

(c) Executive Compensation

Phantom equity is a common compensatory tool used by service recipients (e.g., employers) to provide service providers (e.g., employees, board members, consultants, etc.) with value in an entity that mimics that of an owner without simultaneously providing such service providers with actual ownership rights (e.g., voting, statutory information rights, etc.) in such entity. In addition, phantom equity is, by definition, a broad term and generally encompasses any right of a holder to receive value when the amount of such value is determined by reference to equity in a company, regardless of whether the terms of such arrangement explicitly state that such arrangement is “phantom” equity. Accordingly, parties to a transaction should be cognizant of any potential promises to grant equity, the equivalent value of equity, or any other appreciation or other cash rights that may mimic the value of equity when, in the case of buyers, performing diligence in connection with such transaction, or, in the case of sellers, ensuring proper disclosure against any capitalization or employee benefit plan representations.

The authors would like to thank Michelle Kondratiev for her contribution to this client alert.

^[1] The full definition of “Equity Securities” in the Merger Agreement stated:
a) capital stock, member interests, or equity security, certificate of interest, rights to profits or revenue and any other similar interest in a Person or participation in any profit sharing agreement, preorganization certificate or subscription, transferable share, voting trust certificate or certificate of deposit for an equity security, partnership interest, limited partnership interest, Limited Liability company interest, interest in a joint venture, or certificate of interest in a business trust;
(b) security, warrant, right, put, call, straddle, option or other interest convertible into or exchangeable or exercisable for any of the foregoing, whether at the time of issuance or upon the passage of time or the occurrence of some future event, including any security convertible, with or without consideration, into such a security or any other security carrying any warrant or right to subscribe to or purchase such a security; or
c) warrant or right; or any put, call, straddle, or other option or privilege of buying such a security from or selling from or selling such a security to another without being bound to do so, and in any event “Equity Securities” includes any security having the attendant right to vote for directors or similar representatives.

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