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M&A in Brief: Q2 2023

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1. Chancery Court Provides Additional Guidance on Disclosure Requirements for Corwin Analysis
2. Putting the Brakes on Non-Compete Scope Creep in M&A Transactions
3. Closing the Book on COVID-19 Related MAE Litigation
4. “Sandbagging” Trends in M&A Transactions

1. Chancery Court Provides Additional Guidance on Disclosure Requirements for Corwin Analysis
By Mark Tarallo and Mary Moran

One of the most significant decisions of the Delaware Chancery Court in the last 15 years was the court’s ruling in Corwin v. KKR Fin. Holdings LLC.[1] In Corwin, the court held that a fully informed, uncoerced, and disinterested stockholder vote to approve a merger not involving a conflicted controlling stockholder will “cleanse” a transaction. Where such a vote is taken, Delaware courts will apply the deferential business judgment rule (rather than the more burdensome entire fairness standard) when evaluating post-transaction litigation. 

Galindo v. Stover

Since the decision in Corwin, the Chancery Court has on a number of occasions addressed the adequacy of disclosures in transaction materials. In Galindo v. Stover[2], the Chancery Court provided further guidance on when disclosures are sufficient to apply the Corwin standard. In Galindo, a majority of the stockholders of Noble Energy, Inc. (“Noble”) approved a merger with Chevron Corporation (“Chevron”). After the closing of the transaction, the plaintiffs filed a suit alleging, among other claims, that the price paid by Chevron in the merger was unfair, and that the Corwin standard should not apply because the disclosures provided by management were lacking. The plaintiffs focused on two allegedly faulty disclosures in the merger proxy in particular to claim that the stockholder vote was not fully informed: (i) the failure to mention a prior unsolicited proposal from an unrelated buyer (“Cynergy”) from two years earlier and (ii) the failure to describe with specificity certain changes made to Noble’s 2016 Change of Control Severance Plan for Executives (the “Amended Plan”) and how those changes would result in payouts to executives in connection with the Chevron transaction.

The court began its analysis with a restatement of the Corwin doctrine: “Corwin stands for the general proposition that where a transaction has been approved by a fully informed, uncoerced majority of disinterested stockholders, the business judgment rule applies. This Court will not, in such a situation, second guess the judgment of the stockholders.”[3]. The court then evaluated the disclosure obligations of the directors. “Where a corporation seeks stockholder action, directors of Delaware corporations are responsible for disclosing ‘fully and fairly all material information within the board’s control.’ Directors are required to provide stockholders with ‘accurate and complete information material to a transaction or other corporate event that is being presented to them for action.’”[4]

The court considered the plaintiffs’ claims that the information provided in the merger proxy was incomplete and insufficient because it lacked disclosure of both (1) the Cynergy proposal and (2) further details regarding the Amended Plan. The court quickly dispensed with the idea that any information regarding the Cynergy proposal was necessary, finding that it was not reasonably conceivable that a reasonable investor would have considered the unanswered Cynergy proposal from 2018 important in determining how to vote on a stock-for-stock merger with Chevron in 2020. This failure to mention the Cynergy proposal did not render the stockholders “uninformed” regarding the Chevron transaction.

The court then analyzed the allegations that the failure to describe the details of changes to the Amended Plan also rendered stockholders uninformed. The court noted that the Amended Plan had previously been fully disclosed to stockholders, and that the changes to the Amended Plan would be effective even if the merger with Chevron was not approved. The stockholders were provided with very specific details of the payments that would be made to management in the event the transaction with Chevron was completed. The information alleged by the plaintiffs to have been omitted would not have altered the total mix of information available to stockholders in exercising their vote. 

Material Information is Key

Galindo reinforces the concept that directors need not provide exhaustive information in seeking a stockholder vote. Instead, they must focus on providing stockholders with accurate and complete disclosure of material information. Information is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote, and it must be “of a magnitude that it would, upon disclosure, have ‘significantly’ altered the ‘total mix’ of information in the marketplace.”[5]

Businesses engaging in a merger or similar transaction must always consider obtaining a stockholder vote to cure any potential defects of the transaction process. Obtaining a fully informed, uncoerced, and disinterested stockholder vote to approve a merger not involving a conflicted controlling stockholder will result in the application of the business judgement rule to any post-transaction challenges. Boards and executives must focus on providing information that will be important to the stockholders in determining whether or not to approve a transaction, rather than overwhelming them with information that is not material. As Galindo specifically points out, providing stockholders with specific details of payouts to executives will always be viewed favorably the court with respect to any challenge. 

[1] Corwin v. KKR Fin. Holdings LLC, No. 629, 2014 (Del. Oct. 2, 2015) (en banc).

[2] Galindo v. Stover, C.A. No. 2021-0031-SG (Del. Ch. Jan. 26, 2022).

[3] Id. at 13.

[4] Corwin at 16.

[5] Galindo at 18.

2. Putting the Brakes on Non-Compete Scope Creep in M&A Transactions
By Joshua French and Francesca Oliveira

Non-competition restrictions have always been a key item for negotiation as part of the M&A deal making process, with the definition of “Business” often requiring multiple turns of the document to specify what sellers would be prohibited from doing. Some buyers have taken a broad view of what protection they should receive, arguing that sellers should not be able to compete with the buyer’s business during the restricted period. Recent noteworthy developments, however, could significantly curtail an overreliance on broadly drafted restrictive agreements which unnecessarily obstruct competition.

Challenges to the Future of Restrictive Covenants

In October 2022, the Delaware Chancery Court ruled that overly broad restrictive covenants controlling a target’s employees are against the public interest and the once heavily relied upon “blue pencil” rectifier is an improper use of the courts (Kodiak Building Partners v. Adams). More specifically, broad deal-related restrictive covenants within roll-up strategy acquisitions must be tailored specifically to the target acquisition and cannot apply beyond that scope to the greater parent organization. Meanwhile, a short Amtrak away in Washington, D.C., Federal Trade Commission (“FTC”) regulators are challenging the future of restrictive covenants and their role in a free competitive market. While the proposed rule primarily focuses on employer-employee relationships, it does provide for a narrow M&A exception determined by the employee’s ownership stake in the target company.

Within the M&A context, the decision in Kodiak (the parent company) signals a tide shift favoring employees rather than the employer, finding that the scope of Kodiak’s non-competition provision failed to serve a legitimate business interest. The court acknowledged that, “a buyer has a legitimate business interest in asking the target’s employee to stand down from competing ‘in the relevant industry’ because ‘the buyer has just paid handsomely for the business and the broad non-compete clears the seller from the competitive space while the buyer strives to make the business he just bought successful.’” But, where a restrictive covenant extends beyond the relevant target acquisition to the parent company, inclusive of its unrelated subsidiaries, the restrictive covenant becomes overbroad and unenforceable.

The court focused on the ineffectiveness of the waiver provisions within the restrictive covenant agreement and the unenforceability of the restrictive covenants where language is overly broad and beyond a reasonable scope and refused to give effect to the “blue penciling” provision that permitted a court to rewrite an unenforceable agreement to make it enforceable. The court ultimately held the waiver provision within the restrictive covenant agreement is against the public interest and, therefore, cannot preclude a court from holistically evaluating the agreements with an “eye towards reasonableness, equity, and the advancement of legitimate business interests.” The court further stated, “an employee’s promise not to challenge the reasonableness of his restrictive covenants cannot circumvent this Court’s mandate to review those covenants for reasonableness.” The court highlighted its critical judicial responsibility in balancing “artificial obstacles to competition” and the “important interests of commercial enterprises.”

Even more recently, the FTC proposed a new rule that would almost completely ban employment non-competes with few exceptions. While the proposed rule is quite broad, two carved-out exceptions include non-competes within the M&A context and franchise agreements. Under the proposed rule, non-competes will only apply to those who hold a 25% ownership stake in the acquisition target. 

Reassessing Restrictive Covenant Agreements

Based on the Kodiak decision and proposed FTC restrictive covenant ban, at a minimum, corporate attorneys should reassess the restrictive covenant agreements they use in transactions (particularly in the case of a serial acquiror) to determine their enforceability and applicability. Even if the FTC’s proposed rule does not proceed (or survive), the courts are signaling a movement of increased scrutiny in analyzing restrictive covenants, especially with an eye toward equity and the public interest. The Kodiak decision provides a useful blueprint for analyzing current and future restrictive covenant agreements and determining their appropriate scope to ensure enforceability.

As the courts stray away from the “blue pencil” policy, companies can no longer rely on an instant judicial fix to improper restrictive covenants. Now, they will be held unenforceable and void, disadvantaging the buyer’s position and increasing their risk exposure. Moving forward, the buyer’s counsel should afford special attention to larger parent companies as they acquire subsidiaries, to tailor restrictive covenants to the business of the target, and the seller’s counsel should look for opportunities to limit the scope of restrictive covenants, based narrowly on the acquired business. 

3. Closing the Book on COVID-19 Related MAE Litigation
By Mark Tarallo and Mary Moran

In Level 4 Yoga, LLC v. CorePower Yoga, LLC[1], the Delaware Chancery Court ruled on one of the last remaining cases dealing with material adverse effect (MAE) claims borne out of the COVID-19 pandemic. The court ruled that the buyer, a yoga studio franchisor, had breached the agreement in place to purchase a number of franchised studios and ordered the buyer to close the deal and pay significant damages for the delay. 

CorePower Yoga, LLC and CorePower Yoga Franchising, LLC (collectively, “CorePower”) is one of the largest chains of yoga studios in the country. CorePower’s portfolio consists of both corporate-owned and franchisee-owned studios. Level 4 Yoga, LLC (“Level 4”) operated 29 yoga studios as a franchisee of CorePower. The Franchise Agreement between the parties (the “Franchise Agreement”) gave CorePower the right, at its election, to purchase certain of the yoga studios owned by Level 4. Pursuant to the Franchise Agreement, the parties entered into an additional agreement (the “Call Agreement”) that would instead obligate CorePower to purchase all of the yoga studios owned by Level 4. The Call Agreement contained additional terms that included a formula for determining the purchase price and a requirement that all studios would be purchased at the same time.

In 2019, CorePower exercised its right under the Call Agreement to purchase the Level 4 studios. The parties negotiated some revisions of the terms of the Call Agreement, such as staggered closings, excluding several unbuilt studios from the transaction, and a commitment to enter into a definitive asset purchase agreement (the “APA”). The APA was executed as of November 27, 2019, with staggered closing dates in April, July, and October 2020. The APA did not include any express conditions to either party’s obligation to close, nor did it contain any provision expressly allowing for termination of the agreement, a force majeure clause, or any provision expressly allowing either party to unilaterally postpone any of the staggered closings.

Transaction Delayed

As COVID-19 spread across the country during early 2020, CorePower’s board of directors decided to delay the closing of the transaction. CorePower initially took a position that it had the right to postpone or terminate the transaction because Level 4 was not operating in the ordinary course of business, a requirement of the APA, as it had temporarily closed its studios in response to the pandemic. CorePower did not appear at the first closing, which was scheduled for April 1, 2020. 

Level 4 filed suit against CorePower on April 2, 2020, the day after the first closing was scheduled to occur. Level 4 claimed that CorePower breached the APA in March 2020 by refusing to close on the transaction, failing to deliver certain required payments under the APA, and ultimately failing to take possession of Level 4’s yoga studios. Level 4 requested declaratory relief, specific performance, and damages, including damages incurred by having to maintain the yoga studios while CorePower refused to perform under the APA. The suit ultimately went to trial, and the case was submitted for decision on December 23, 2021.

Chancery Court Reasoning

After trial, the court ruled in favor of Level 4, in a memorandum opinion dated March 1, 2022. The court found that the APA was a “one-way gate,” as it “unambiguously contain[ed] no conditions to closing and no express right for either party to terminate the contract pre-closing. Nor [were] there provisions in the APA that somehow [implied] a pre-closing right to terminate.”[2]. The court noted that, while the agreement was heavily negotiated and contained numerous buyer-friendly protections such as a purchase price adjustment clause, a “hearty post-closing indemnification regime,” no anti-sandbagging provisions, and the lack of a termination right showed clear intent by the parties that the transaction was to close, with any needed changes to the terms taking place post-closing.

The court considered and rejected CorePower’s claims that a material adverse effect or “MAE” had occurred that entitled the buyer to terminate the deal under the terms of the APA. The APA defined an MAE as “a material and adverse effect on the business, assets, liabilities, financial condition, property or results of operations of the Seller, taken as a whole.” In evaluating whether an MAE had occurred, the court considered the nature of the purchase as part of a long-term strategy, since “[t]o such an acquiror, the important thing is whether the company has suffered a Material Adverse Effect in its business or results of operations that is consequential to the company’s earnings power over a commercially reasonable period, which one would think would be measured in years rather than months.” As the COVID-19 shutdown had only been in place for a matter of days prior to the first closing, the court found that CorePower could not have any basis for determining that an MAE had occurred. The court also ruled that Level 4 had not deviated from its “ordinary course of business” by closing studios during the pandemic, because those closures had been directed by CorePower and Level 4 was obligated, under the Franchise Agreement, to follow such directions.

Importance of Termination Provisions

Given the court’s reliance on the lack of termination provisions and its characterization of the APA as a “one way gate,” this decision highlights the importance of including clear and specific termination provisions and closing conditions in transaction documents. It also highlights the need to include the underlying purchase option documents when a transaction is undertaken pursuant to an option or call right (the court relied on the fact that the call option exercised here did not contain any termination rights or conditions). Finally, this case highlights the Chancery Court’s reluctance to find a material adverse effect that would entitle a party to terminate. Accordingly, practitioners should look instead to breaches of representations and warranties not qualified by material adverse effect language when attempting to terminate a transaction. 

[1] Level 4 Yoga, LLC v. CorePower Yoga, LLC, C.A. No. 2020-0249 (Del. Ch.).

[2] Id. at 27-28.

4. “Sandbagging” Trends in M&A Transactions
By Robert Lynch and Meghan Kelly

In March 2022, Delaware’s Court of Chancery affirmed that Delaware is a “pro-sandbagging jurisdiction” in Arwood v. AW Site Services, LLC , C.A. No. 2019-0904-JRS (Del. Ch. March 9, 2022), by holding that the buyer in the business acquisition in question could succeed against the seller on a breach of contract claim regarding the seller’s misrepresentations under the parties’ purchase agreement, regardless of whether the buyer knew of such misrepresentation prior to closing the transaction. “Sandbagging” occurs when the buyer knows about a false representation or warranty of the seller in a purchase agreement but closes the transaction anyway and then later brings a claim for damages resulting from the seller’s breach of contract due to the false representation or warranty. Generally, a buyer’s knowledge of something can be implicated either through actual knowledge or “constructive knowledge,” which occurs when the buyer is legally presumed to know something because they should have known it after conducting a reasonable level of diligence. However, the court in Arwood noted that sandbagging is only implicated under Delaware law if the buyer had actual knowledge of the misrepresentation, providing the seller with narrower avenue to raise a sandbagging defense. In Arwood, the court found that the buyer did not have actual knowledge of the misrepresentations in question, and therefore litigating whether the buyer should have known about the breach would be irrelevant to the sandbagging inquiry.

Purchase agreements may directly address sandbagging through “pro-sandbagging” provisions (i.e., allowing the buyer to sandbag the seller post-closing) or “anti-sandbagging” provisions (which prohibit the buyer from sandbagging). In Arwood, the purchase agreement contained an explicit pro-sandbagging provision, and the court noted that to rule against a provision that was specifically bargained for in the purchase agreement would be “inconsistent with [Delaware’s] profoundly contractarian predisposition” (i.e., that Delaware generally looks to uphold contractually agreed to provisions, rather than overturn them on equitable [fairness] grounds). For contracts that are silent on the issue of sandbagging, the default rules of the governing law of the contract will control. In Arwood, the court opined that even if the purchase agreement in question was silent as to sandbagging, the buyer’s breach of contract claim would still have succeeded, thus affirming the default position of Delaware law as “pro-sandbagging.”

Potentially Significant Consequences

The decision in Arwood will have important consequences for many buyers and sellers in future mergers and acquisitions activity because Delaware law is a typical choice for the governing law of a purchase agreement in corporate transactions. It should be noted however, that the Delaware Supreme Court has not definitively ruled on the issue of sandbagging, and therefore, it is possible that a future case in front of that court could overrule or distinguish the holding in Arwood.

The potentially significant consequences to a seller of being sandbagged by a buyer may lead one to assume that including an anti-sandbagging provision is the norm for M&A deals; however, in the American Bar Association’s 2021 Private Target Mergers and Acquisitions Deal Points Study (the most recent of this biennial publication), only 2% of transactions surveyed included anti-sandbagging language, compared to 29% that included a pro-sandbagging provision. The study found 68% of such transactions in 2021 were silent on the issue of sandbagging (and therefore the law of the jurisdiction governing the contract would control). In general, the ABA study showed a sharp increase in contractual silence on the issue of sandbagging over a four-year period (up from 51% in 2017), and corresponding decrease in pro-sandbagging language (down from 42% in 2017), while anti-sandbagging also decreased (down from 6% in 2017). Thus, it appears that leaving it to state law to determine whether sandbagging is allowed, rather than expressly addressing the issue one way or another in the contract, is the current market standard, and if the governing law is Delaware, based on the decision in Arwood, the outcome of a breach of contract dispute regarding a seller misrepresentation will likely be a pro-sandbagging result.

Representation and Warranty Insurance

The inclusion of a representation and warranty insurance (RWI) policy in connection with an acquisition adds an additional wrinkle, as such policies may include a provision that if the buyer knew of a false representation or warranty, the resulting breach would be excluded from coverage. The practical implication  is that a pro-sandbagging provision in the purchase agreement becomes of less use to the buyer with respect to matters covered by the buyer’s RWI policy, particularly when there is no contractual indemnification obligation of the seller (and such “no-indemnity” purchase agreements are more common when the buyer obtains an RWI policy, as the policy can serve as an alternative to the seller agreeing to indemnify the buyer for misrepresentations in the contract). Accordingly, SRS Acquiom’s 2022 Deal Terms Study, when comparing transactions from the last three years, found that transactions with an RWI policy identified included pro-sandbagging language 33% of the time and were silent 65% of the time (consistent with the ABA’s overall 2021 totals); however, transactions with no RWI policy identified included pro-sandbagging language 59% of the time and were silent only 38% of the time (almost flipping the totals). This significant trend of including pro-sandbagging language in deals where no RWI policy is identified highlights the impact of the RWI policy on sandbagging negotiations and hints at the rising prevalence of RWI in the M&A space.

The Importance of State Law

The general trend toward contractual silence with regard to sandbagging underscores the importance of the state law that governs the contract. While the governing law of a contract may seem like a low priority item to a buyer or seller focused on due diligence and the myriad of other items to negotiate in the typical M&A transaction, selecting a jurisdiction that leans pro-sandbagging, such as Delaware, can have significant consequences for buyers and sellers if the parties choose not to (or are unable to) negotiate sandbagging terms in the purchase agreement itself, which has increasingly become the norm. Furthermore, buyers are well served to review their RWI policies carefully for anti-sandbagging-like language in the policy that may affect their ability to collect under the policy, even if they have negotiated pro-sandbagging language in the purchase agreement or have the benefit of a pro-sandbagging jurisdiction.

This update is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.

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