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Delaware Court Rules That a Buyer May Terminate a Merger Agreement Based on the Breach of a Capitalization Representation

In a decision rendered on May 29, 2023, the Delaware Court of Chancery, in the case HControl Holdings LLC et al. v. Antin Infrastructure Partners S.A.S. and OTI Parent LLC,¹ enforced a buyer’s right to terminate a merger agreement on the basis that certain representations made by the sellers in the merger agreement concerning the target companies’ capitalization were not true and correct in all respects. Factual Background Antin Infrastructure Partners S.A.S., a private equity firm formed under French law, and OTI Parent LLC (collectively, the Buyers) entered into a merger agreement (Merger Agreement) with the Purchased Entities (as defined below) and Mario Bustamante, as the sellers’ representative (together with the Purchased Entities, collectively, the Sellers) to acquire a group of privately held Florida broadband companies, collectively referred to as OpticalTel, for a base purchase price of $230 million plus an earnout of up to $30 million contingent on meeting certain milestones after closing. OpticalTel consists of four top-level limited liability companies (collectively referred to as the Purchased Entities) and their subsidiaries. The Merger Agreement is governed by Delaware law. Under the Merger Agreement, the Sellers made representations and warranties concerning who owned the businesses being sold (Capitalization Representations) and agreed that all Fundamental Representations, which were defined to include the Capitalization Representations, would be true and correct in all respects at closing (the Bring-Down Provision). During negotiations, the Sellers and Buyers went back and forth on whether a de minimis failure of the Fundamental Representations to be true and correct would be excluded from the Bring-Down Provision. Ultimately, the Sellers and Buyers agreed on a flat Bring-Down Provision that would require the Fundamental Representations, including the Capitalization Representations, to be true and correct in all respects at closing and would not include a de minimis qualification. After the Merger Agreement was signed, an employee of OpticalTel, Rafael Marquez, claimed an ownership interest in an OpticalTel entity, HControl Corporation (HControl Corp.), a subsidiary of one of the Purchased Entities, HControl Holdings LLC, based on a software development agreement entered into with Marquez pursuant to which he provided certain services related to the implementation of software used in OpticalTel’s business. The software development agreement provided for HControl Corp. to pay Marquez, as consideration for his services, among other things, “5% ownership of HControl Corp. to be distributed upon a liquidation event.” The interest that Marquez claimed he had in HControl Corp. was not included in the disclosure schedule to the Merger Agreement relating to the Capitalization Representations. Marquez aggressively pursued his claim, including by directly contacting the Buyers. The Sellers made several attempts to settle with Marquez and ultimately made an offer to him of $300,000, based on a $9.5 million valuation of HControl Corp., which was rejected. Marquez’s counsel made an offer of $4.5 million to $5.4 million to resolve the claim, based on Marquez’s position that he was entitled to 5% of the total deal proceeds, not only the proceeds attributable to HControl Corp. The Sellers were unable to reach a settlement with Marquez. The Sellers then proposed restructuring the merger transaction to exclude HControl Corp. and provide the other OpticalTel entities with access to its software via a licensing arrangement. The Buyers rejected this proposal and shortly thereafter served a notice of breach of the Merger Agreement on the Sellers based on a breach of the Capitalization Representations. The Sellers then proposed a plan (the Transfer-Dissolution Plan) to transfer HControl Corp.’s proprietary software to HControl Holdings – one of the Purchased Entities that would be acquired by the Buyers in the merger – in exchange for $215,000, or 5% of the software’s valuation of $4.3 million, paid into a trust and then dissolve HControl Corp., with the objective of reducing any claim to equity by Marquez to a claim for monetary damages. The Buyers took the position that the Transfer-Dissolution Plan would breach certain interim covenants regarding the Sellers’ operation of the OpticalTel business between signing and closing, and they noted that the dissolution process could take months and the statute of limitations period for bringing claims against HControl Corp. would extend for another four years. The Sellers responded by seeking the Buyers’ consent to the Transfer-Dissolution Plan. The Buyers did not consent. Nonetheless, the Sellers went forward and consummated the Transfer-Dissolution Plan. Following the Sellers’ consummation of the Transfer-Dissolution Plan, the Buyers sent a second notice of breach, stating that the dissolution of HControl Corp. failed to resolve the Sellers’ breach of the Capitalization Representations related to Marquez and resulted in further breaches of the Merger Agreement. Shortly thereafter, the Buyers terminated the Merger Agreement due to the Sellers’ failure to cure the breach of the Capitalization Representations relating to Marquez, and about a month after that, the Buyers sent another notice terminating the Merger Agreement due to the Sellers’ failure to cure their breaches of the Merger Agreement arising out of the Transfer-Dissolution Plan and certain other breaches. The Sellers filed suit against the Buyers for specific performance. The Sellers claimed that the Buyers breached the Merger Agreement by, among other things, wrongfully terminating the Merger Agreement and failing to use their best efforts to consummate the merger. The Court’s Findings The court found that Marquez’s rights under the software development agreement to a cash payment upon a liquidation event in the amount of 5% of the value of HControl Corp. constituted phantom equity, which rendered the Capitalization Representations false, and that the Transfer-Dissolution Plan did not cure the Sellers’ breach of the Capitalization Representations. The court noted that the Bring-Down Provision does not include a de minimis qualifier. The Buyers negotiated for the Fundamental Representations, including the Capitalization Representations, to be true and correct in all respects. The Capitalization Representations were not true and correct in all respects, and the Buyers proved that the Sellers breached the Capitalization Representations based on the Marquez issue. In its decision, the court noted that the parties disputed the Buyers’ motive for serving notice of breach and that the Sellers came to believe that the notice had something to do with an investigative report on the OpticalTel companies, the principal owner and the CEO that was prepared by a third party that the Buyers commissioned upon learning about the Marquez issue. The report cast a number of aspersions on the Sellers that the Sellers denied. The Sellers pointed to this report as the impetus behind the Buyers’ decision to back out of the deal and insinuated that the Buyers’ legal grounds were pretextual. However, the court found that the Buyers’ representatives testified credibly that the Marquez issue concerned them. In that regard, the Buyers acknowledged that the post-closing risks related to Marquez were not primarily financial and that they viewed Marquez’s claim as worth a minimal amount of money compared to the deal. The Buyers believed that Marquez would continue to pursue his claims aggressively post-closing and that litigation would consume and distract the Sellers’ management. The Buyers also had reputation concerns related to the Marquez issue. Notwithstanding the analysis in the court decision concerning the Buyers’ motives, the court noted that, in all events, the parties’ dispute over the Buyers’ motives was largely beside the point and the real issue was whether they had a legal basis to notice a breach and terminate the Merger Agreement. The court found that the Sellers did not prove that the Buyers breached their obligation to use best efforts to close, noting that the Buyers continued to take specific steps to proceed to closing even after learning about the issue involving Marquez. The court stated that between signing and closing, the Buyers had the right not to close if the Capitalization Representations were not true and correct in all respects and that the best-efforts provision did not require the Buyers to sacrifice their negotiated contractual rights to solve a breach. The court held that the Buyers had the right to terminate the Merger Agreement as a result of the Sellers’ breach of the Capitalization Representations with respect to the Marquez issue. However, with regard to the Transfer-Dissolution Plan, the court found that the consummation of the Transfer-Dissolution Plan neither breached the Sellers’ obligations under the Merger Agreement to operate OpticalTel in the ordinary course of business between signing and closing or use commercially reasonable efforts to preserve intact its business organization nor breached the provision of the Merger Agreement that prohibits the Sellers from dissolving any member of the OpticalTel companies, other than immaterial subsidiaries, without the Buyers’ consent. The court found that the Optical-Tel business was not altered by the transfer of the assets of HControl Corp. to HControl Holdings because the OpticalTel companies still held the assets following such transfer and noted that before and after the transfer, the OpticalTel companies owned the same assets and had the same contracts and that the business was essentially the same as it was at the time of the signing of the Merger Agreement. The court also found that while HControl Corp. was a material subsidiary before the consummation of the Transfer-Dissolution Plan, it was not a material subsidiary after its assets were transferred pursuant to the Transfer-Dissolution Plan. Nevertheless, the court’s findings with regard to the Transfer-Dissolution Plan did not affect the Buyers’ right to terminate the Merger Agreement based on the breach of the Capitalization Representations. Conclusion This case indicates that (i) the Delaware courts may enforce the right of a buyer to terminate a merger agreement based on the failure of a seller’s representations and warranties to be true and correct at closing even where the financial value of the breach is minor relative to the overall deal value if the terms of the merger agreement require the applicable representations and warranties to be true and correct in all respects at closing (without any de minimis or materiality qualification) and (ii) any obligation of the parties under a merger agreement to use best efforts to consummate the merger may not require a buyer to take actions to assist a seller with curing the seller’s breach of representations and warranties in order to satisfy a condition to the buyer’s obligation to consummate the merger. Accordingly, counsel for buyers and sellers should give careful consideration in negotiating such bring-down provisions and the extent to which those provisions should be qualified by materiality. ¹ 2023 WL 3698535 (Del. Ch. May 29, 2023)   Meet the Author Jason Jones Jason Jones is engaged in the practice of business law, with particular emphasis on mergers and acquisitions of middle-market businesses; organizing and structuring corporations, limited liability companies and other business entities; and drafting and negotiating shareholders’ agreements and business contracts. His experience includes advising clients with respect to cross-border transactions, the private placement of securities, and the liquidation and dissolution of corporations and other business entities. jjones@stradley.com 215.564.8194

Delaware Court Rules That a Buyer May Terminate a Merger Agreement Based on the Breach of a Capitalization Representation

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