In our January 2015 newsletter we discussed the recent decision of the Delaware Court of Chancery in the Cigna Health & Life Company v. Audax Health Solutions, Inc. case, which invalidated two purchaser-imposed requirements that are frequently found in private company mergers, specifically the conditioning of payment of merger consideration on receipt of a stockholder release and stockholders’ obligation for certain post-closing indemnity obligations not covered through an escrow. In response, some purchasers are insisting that the target company stockholders who consent to a merger (through a joinder agreement or other agreement signed by certain stockholders) stand behind 100% of all post-closing indemnity obligations. In other words, the consenting stockholders are being asked to bear the risk that non-consenting stockholders will not be bound by certain indemnity obligations. While practitioners are continuing to debate how broadly or narrowly to read the Court’s decision, risk averse buyers have been seeking to shift the risk to the target company stockholders and force targets to obtain agreements from nearly all stockholders, giving minority stockholders potential deal hold-up rights, increasing transaction costs and diminishing the structural advantages of using a merger.
In another recent decision, Halpin v. Riverstone National, Inc. (February 2015), the Delaware Chancery Court questioned whether a prospective waiver of appraisal rights by a common stockholder is valid under Delaware law and created another potential deal structuring issue with minority stockholders. Stockholders agreements of private companies frequently include prospective appraisal rights waivers in the form of drag-along provisions. Private equity sponsors and founders rely on drag-along provisions to compel minority stockholders (often employees or other early investors) to participate in certain qualifying sale transactions. Because cash out mergers are frequently used to sell privately-held companies (instead of direct stock sales), drag-along provisions frequently compel the stockholders to vote in favor of the adoption of the merger agreement. Voting in favor of a merger makes a stockholder ineligible for appraisal rights. Some stockholders agreements go further and include an express waiver of appraisal rights on a future sale of the company.
Prior to the Riverstone case, the Delaware Chancery Court has held that preferred stockholders may waive appraisal rights ex ante by contract where the intent to waive the right is clear. In the Riverstone decision, the Chancery Court questioned whether the same rationale applies to common stockholders because the rights of common stockholders are principally governed by statute and common law fiduciary principles. While many M&A parties and practitioners have assumed that appraisal right waivers are valid, the Delaware courts have not directly ruled on the question. Consequently, some practitioners have recommended seeking contemporaneous appraisal right waivers in connection with an actual transaction rather than relying on drag-along provisions alone. In the near term, the Riverstone decision could further diminish the advantages of structuring a sale as a merger and relying on drag-along provisions.
Similar to many stockholders agreements for privately-held companies, the Riverstone stockholders agreement granted the target corporation the power, subject to certain restrictions (e.g., same price and terms), to require the minority stockholders to tender and/or vote their shares in favor of certain change of control transactions approved by a majority of the target’s stockholders. The Riverstone agreement did not include an express waiver of appraisal rights. In this case, the 91% controlling stockholder of Riverstone approved the merger agreement and merger, and the parties closed the merger before the notice of appraisal rights was sent to the non-consenting stockholders and before the period for exercising appraisal rights had lapsed. After the closing, Riverstone sent an information statement to the minority stockholders informing them that the majority stockholder had approved the merger agreement and that the closing had occurred. The information statement attempted to invoke the drag-along right to compel the minority stockholders to consent to the merger in order to make the minority stockholders ineligible to exercise statutory appraisal rights. The information statement informed the minority stockholders that they may be entitled to appraisal rights under Delaware law but that the cash merger payment would only be available to stockholders who relinquished that right by signing the attached written consent. One of the minority stockholders (which happened to be a competitor of the purchaser) refused to sign the written consent and brought appraisal actions. Riverstone counter-claimed and sought to have the drag-along rights specifically enforced.
The minority stockholders argued that the drag-along right was unenforceable because a common stockholder cannot waive its statutory right to appraisal ex ante—here, in a stockholders agreement in return for consideration that is to be set later by the controlling stockholder. In the final analysis, the Court decided the case on narrower grounds. The Court assumed that prospective waivers could be valid but held that Riverstone did not exercise its drag-along rights in accordance with the unambiguous language of the stockholders agreement, which did not allow the drag-along rights to be exercised after the merger was consummated. In other words, because the target company did not demand a vote in favor of the sale before the merger was accomplished as required by the stockholders agreement, Riverside may not specifically enforce the drag-along rights, even if a waiver of appraisal is otherwise enforceable.
The minority stockholder also argued that drag-along rights should only be enforceable if they are exercised prior to the closing of the sale. Otherwise, minority stockholders would not be able to seek to avoid an oppressive merger by application to the Delaware Chancery Court. The Court also did not rule on this point in its decision.
Pending further guidance from the Delaware courts, model stockholders agreements should include drag-along provisions that compel stockholders to vote in favor of deal prior to closing or after closing and require them to sign a written consent to a transaction subject to a drag-along right within a specified period of time after receiving notice of the transaction. We also recommend including an express waiver of appraisal rights as part of the drag-along provisions. Controlling stockholders should also carefully review and follow the procedures set forth in the drag along provisions. If Riverstone had included an express waiver of appraisal rights in its stockholders agreement and/or exercised the drag-along rights in accordance with their terms, it is possible the outcome of the case may have been different and forced the Court to decide whether prospective waivers are valid. Some practitioners are also considering forming companies as LLCs rather than corporations as a structural solution because LLCs are largely contractual and could include prospective waivers of appraisal rights. This solution may not work for companies that have venture capital or other investors who are required to invest in C corporations.
In many private company mergers, the parties may not be overly concerned about the actual threat of minority stockholders exercising appraisal rights. In most cases, smaller common stockholders and employee stockholders will want their cash proceeds as soon as possible and not want to deal with the delay and expense of an appraisal proceeding, especially where the transaction is an arms-length deal with no conflict of interest concerns. Nevertheless, purchasers seek certainty and frequently negotiate to shift the risk to the selling stockholders—by imposing closing conditions that limit the percentage of shares that exercise or remain eligible to exercise appraisal rights as of closing and by obligating the selling stockholders to indemnify the purchaser for any amounts paid on account of appraisal actions in excess of the deal price and the expense of appraisal actions.
If drag-along rights must be exercised prior to closing—either by the terms of the stockholders agreement or to ensure enforceability—target companies will need to approach stockholders prior to closing. If the transaction requires regulatory approvals or otherwise requires a post-signing period to satisfy closing conditions, the stockholders can be notified after signing. But in transactions where a simultaneous signing and closing are possible, this would mean approaching the stockholders prior to signing and announcement. Whether this is feasible will depend on considerations specific to a particular transaction, including the composition of the stockholder base, confidentiality concerns, etc. If it is not feasible to approach the minority stockholders prior to signing, the parties will need to provide for a period between signing and closing.