The Williams Companies v. ETE: Chancery Court Allows Termination of Merger Agreement, Finding Good Faith and No Breach of Efforts Covenant by Buyer | Practical Law

The Williams Companies v. ETE: Chancery Court Allows Termination of Merger Agreement, Finding Good Faith and No Breach of Efforts Covenant by Buyer | Practical Law

The Delaware Court of Chancery ruled that Energy Transfer Equity, L.P. had not breached its merger agreement with The Williams Companies, Inc. as a result of its counsel's determination that it could not provide an opinion that the transaction should be treated as tax-free.

The Williams Companies v. ETE: Chancery Court Allows Termination of Merger Agreement, Finding Good Faith and No Breach of Efforts Covenant by Buyer

by Practical Law Corporate & Securities
Published on 30 Jun 2016 • Delaware, USA (National/Federal)
The Delaware Court of Chancery ruled that Energy Transfer Equity, L.P. had not breached its merger agreement with The Williams Companies, Inc. as a result of its counsel's determination that it could not provide an opinion that the transaction should be treated as tax-free.
In a widely publicized decision on a contested merger agreement scheduled to go to a stockholder vote three days later, the Delaware Court of Chancery ruled in The Williams Companies, Inc. v. Energy Transfer Equity, L.P. that acquiror Energy Transfer Equity (ETE) was authorized to terminate its agreement with target company The Williams Companies, Inc. (WMB) once the drop-dead date for closing passes (C.A. No. 12168-VCG, C.A. No. 12337-VCG (Del. Ch. June 24, 2016)). The court held that ETE's counsel Latham & Watkins LLP had concluded in good faith that it could not deliver an opinion on the tax-free treatment of the merger and that Latham's subjective judgment was adequate to render the relevant closing condition in the agreement unsatisfied.
Though highly fact-specific, the decision contains several takeaways that are useful under broader circumstances, including the court's interpretation of the "commercially reasonable efforts" covenant standard and the distinction between recalcitrant buyers in this case and the 2008 decision in Hexion v. Huntsman.

Background

The case stems from the merger agreement dated September 28, 2015, among ETE, WMB, and several ETE affiliates. For a summary of the agreement, see What's Market, Energy Transfer Equity, L.P./The Williams Companies, Inc. Merger Agreement Summary. The agreement contemplated a unique and complex structure that was intended to provide a significant cash payment to WMB's stockholders while preserving the tax-free treatment of the transaction. Relevant to the dispute, the agreement called for two transactions between ETE and the merger entity it created for the transaction, Energy Transfer Corp LP (ETC). In one transaction, ETE would transfer $6.05 billion to ETC in exchange for ETC shares representing 19% of ETC's equity. That payment would then be distributed directly to the former WMB stockholders. In the other transaction, ETC would contribute WMB's assets to ETE in exchange for newly issued partnership units.
The parties and their counsel theorized that the contribution of assets to the partnership ETE would not be treated as a sale, but as a tax-free contribution of property under Section 721(a) of the Internal Revenue Code. Section 721(a) provides that no gain or loss is recognized to a partnership in the case of a contribution of property to the partnership if an interest in the partnership of equal value is given back in exchange. To give comfort that the IRS would agree that the $6 billion transfer was not taxable, the parties agreed to include a mutual closing condition in the merger agreement stating that closing is conditioned on ETE's tax counsel Latham providing an opinion, dated as of the closing date, that the transaction should qualify as tax-free under IRC Section 721. At the time of the signing, Latham believed that it could deliver the opinion and it considered the underlying issues "fairly straightforward."
In the ensuing months, the energy sector, and with it ETE, experienced significant declines in the market, and ETE grew increasingly concerned about the debt financing for the cash payment. In December 2015, ETE began considering renegotiating the terms of the merger agreement, and by January 2016, its former CFO testified, ETE would have preferred terminating the agreement to restructuring it.
As the value of ETE's units (and by extension, ETC's shares) dropped, ETE became aware of a problem it had not considered previously regarding the tax-free status of the transaction. Driving its concern was that the number of ETC shares being exchanged for the cash payment was fixed at 19% of ETC's equity, not floating as ETE's unit price rose or fell. Consequently, with the decline in ETE's unit price, ETE stood to receive ETC shares that were worth only $2 billion, far less than the $6 billion it was obligated to pay. ETE and Latham worried that the $4 billion overpay would be attributed to the contribution of property to ETE and the contribution would be treated as a disguised sale under IRC Section 707. Latham devoted considerable time and manpower to solving this dilemma, but concluded that it could not give the Section 721 opinion.
For their part, WMB and its deal counsel were certain that ETE had conjured the entire taxation theory out of buyer's remorse, had manufactured a premise for avoiding having to close, and had surely directed Latham to assert that it could not give the opinion. WMB added that ETE's efforts to scuttle the transaction amounted to both a breach of its covenant to exert commercially reasonable efforts to obtain the opinion and a breach of its representation that it knew of no facts that would reasonably prevent the tax-free treatment of the contribution transaction. WMB therefore asked the court to declare that even if Latham will not deliver the opinion, ETE be estopped from terminating the agreement because of its own material breaches.
ETE asked the court for the opposite declaration, that the closing condition was legitimately unmet and that it had the right to terminate the agreement on passage of the drop-dead date.

Outcome

The court ruled in favor of ETE, holding that despite any oversight in the transaction structuring, Latham had determined in good faith that it could not deliver the Section 721 opinion and ETE had a contractual right to enforce the closing condition.

Closing Condition Unmet

Much of the decision comes down to a balancing between the obvious benefit to ETE of suddenly realizing that the closing condition could not be met, weighed against the unlikelihood that Latham would risk reputational harm, as WMB alleged it was doing, by bowing to ETE's demand not to give the opinion against its own professional judgment. The court acknowledged the "truism" that lawyers have a way of responding to the demands of their clients and that ETE would be quite lucky to stumble into a free exit for a deal it could no longer afford. However, the court ultimately found that luck, and not anything more conniving, was on ETE's side.
Of primary importance for the court was the competing testimony of counsel and experts at trial, with several opinions offered to varying degrees of certainty about the likely tax treatment of the contribution transaction. This range of opinion indicated to the court that the tax issue was a close call and not obvious in either direction. The court also credited the testimony of Latham's tax partners that they would not reach a conclusion against their own judgment, particularly when Latham's reversal on the tax opinion could have repercussions for the firm's reputation. Tying these findings back to the merger agreement, the court noted that the closing condition did not call for the opinion of an independent third party or another objective standard. Rather, the condition was that Latham would give a "should opinion"—a term of art meaning that it is quite likely that the firm's opinion will be upheld. The court considered this a matter for Latham's subjective good-faith determination of the treatment of the transaction, and that Latham had decided in good faith that it could not deliver the opinion.

No Breach of Efforts Covenant

The court also ruled that ETE was not estopped from enforcing the closing condition because it had not breached its efforts covenant. In reaching that decision, the court first addressed the "commercially reasonable efforts" standard, which it acknowledged has not been addressed with "particular coherence" in Delaware common law. For a relevant analog, the court cited to its decision in Hexion Specialty Chemicals, Inc. v. Huntsman Corp., which addressed an agreement with a "reasonable best efforts" standard. In Hexion, the court concluded that the "reasonable best efforts" standard requires "good faith in the context of the contract at issue" (965 A.2d 715 (Del. Ch. 2008)) (quote taken from ETE). The court in ETE held that the "commercially reasonable efforts" standard similarly contemplates an objective standard—in particular, that ETE had to do "those things objectively reasonable to produce the desired 721 Opinion, in the context of the agreement reached by the parties."
Based on that standard, the court ruled that even though ETE had experienced buyer's remorse over the deal and might have been motivated to "use methods fair or foul" to avoid closing, WMB had not explained what actual efforts ETE should have undertaken to somehow make the opinion deliverable. WMB argued that ETE, by publicly disclosing Latham's decision not to render the opinion, had "boxed in" Latham by making it even more embarrassing for Latham to eventually change its mind back to giving the opinion. WMB added that regardless of its inability to describe the actions that ETE should have taken, ETE's efforts covenant required it to prove that its inaction was not the reason why Latham could not deliver the opinion. In a more generalized way, WMB contended that ETE simply had not acted like a party attempting to get to closing, much like Hexion in 2008 when it publicly announced that going through with the transaction would render it insolvent (for a detailed description of the Hexion/Huntsman litigation, see Article, In Dispute: Hexion/Huntsman).
The court rejected these arguments and distinguished Hexion's conduct from ETE's. Here, ETE had alerted its own counsel to a potential issue, which it was entitled to do. It also had no obligation to prove that its lack of more forceful action did not cause Latham's inability to deliver the opinion. On the contrary, if a defendant is shown to have committed a breach, it has the right to an affirmative defense that the consequences of the breach were unavoidable regardless.
By contrast, Hexion's announcement that closing the deal with Huntsman would render it insolvent had the effect of driving away third-party financiers. That additional effect was the key to the finding that it had breached its covenant to exert its reasonable best efforts to obtain financing for the deal. ETE's announcement had no similar effect on any third parties, including on Latham, in light of the court's finding that Latham had decided in good faith that it could not deliver the opinion.

No Misrepresentation

The court also ruled that ETE was not in breach of its tax representation. The representation stated:
"None of [ETC], [ETE], or any Subsidiaries of [ETE] has taken or agreed to take any action or knows of the existence of any fact that would reasonably be expected to prevent . . . (B) the Contribution and [Issuance of units] from qualifying as an exchange to which Section721(a) of the Code applies."
The representation thus required ETE to disclose any facts that it was aware of that would render the transaction taxable, which it had done. WMB's complaint, as the court explained, was that ETE should have disclosed the analysis, which was only arrived at after the signing, that the transaction as structured bore risk of being taxable. But this is not a "fact" that requires disclosure; it is a theory of tax liability, which the representation does not mandate be disclosed.

Post-Judgment Developments

The decision was issued on June 24, 2016. The stockholders of WMB approved the transaction on June 27. On June 29—the day after the agreement's drop-dead date for closing—ETE announced that it had terminated the agreement. WMB has appealed the Chancery Court's decision and has announced its intentions to seek damages against ETE. The Wall Street Journal and New York Times report that on June 30, 2016, half the board of WMB resigned after the board split evenly on whether to fire the company's CEO in light of the failed merger.

Practical Implications

Much of the decision involves facts and circumstances that are unlikely to repeat all that frequently. Nevertheless, several principles from the decision are worth highlighting:
  • Unexpected obstacles to closing. The decision above all is a reminder that even seemingly airtight merger agreements can contain gaps that virtually no one involved in the transaction knew were there. In this case, a seemingly innocuous closing condition calling for a tax opinion managed to upend an agreement that otherwise called for specific performance and no limitation on post-termination damages for breach. The circumstances that led to this deal's failure are unique and not likely to be duplicated often, but counsel should still consider whether the case is instructive. For example, in complicated transactions, counsel should consider whether a tax opinion should only opine as to the tax-free treatment of the merger as of the signing, or opine as of the closing on the basis of the buyer's stock price as of the signing.
  • Motive alone does not establish misconduct. Much of WMB's argument rested on an assertion that ETE must have breached the agreement because the inability of its own counsel to render a tax opinion was too convenient. The court acknowledged that it came to the case with a "skeptical eye," but ultimately determined that ETE fairly had a right to enforce the closing condition, as lucky as that made ETE. In the court's description, "even a desperate man can be an honest winner of the lottery."
  • Efforts standards nearly indistinguishable. Rightly or wrongly, M&A practitioners often assume that there is a hierarchy of efforts standards, with "best efforts" being the most onerous and "reasonable best efforts" also requiring a substantial amount of effort and expense, while "commercially reasonable efforts" is presumed to be the most forgiving standard of the three. Indeed, Practical Law's annual study of remedies surveys the financing covenants in the previous year's leveraged deals and tracks the usage of each of these standards. The decision in ETE, however, gives no support to the assumption that there is a meaningful distinction between "reasonable best efforts" and "commercially reasonable efforts." In defining "commercially reasonable efforts," the court essentially relied on Hexion's definition of "reasonable best efforts" and took for granted that they both imply an objective standard of efforts in the context of the overall agreement.
  • Efforts covenant does not require proving a negative. WMB argued that as a consequence of its efforts covenant, ETE should have to prove that its inaction was not the cause of Latham's inability to render the tax opinion. WMB based this argument on the Chancery Court's decision in WaveDivision, which stands for the principle that where a party's breach by non-performance contributes materially to the failure of a condition, the failure of the condition is waived off (WaveDivision Hldgs., LLC v. Millennium Digital Media Sys., LLC, , at *14 (Del. Ch. Sept. 17, 2010)). However, the court treated this principle as inapposite. Even a breaching party still has the defense available to it in litigation that the consequences of the breach were inevitable regardless of whether or not it breached the covenant.
  • Conduct in Hexion distinguished. For many observers, the case was an instant reminder of Hexion v. Huntsman, with each case having a remorseful buyer who hoped that an advisor's opinion would support its argument. The critical difference was that in Hexion, the buyer fed its advisor misleading or inaccurate information to obtain an opinion that would actively undermine its financing covenant. ETE could not be accused of similar behavior; it had only raised an issue with its counsel and otherwise let its counsel think through the implications. The court acknowledged that had ETE coerced or mislead Latham in such a way that prevented Latham from issuing the Section 721 opinion, the ruling would likely be different.