December 4, 2014

Delaware Court Invalidates Release and Indemnification Obligations Against a Selling Stockholder in a Merger Transaction

The Delaware Chancery Court recently invalidated a buyer’s attempt to obtain a release and indemnification obligations from selling stockholders of a Delaware corporation that was acquired in a merger. The ruling will require buyers to develop alternative structures or techniques to ensure that indemnification and other obligations that it may seek to impose on selling stockholders are enforceable.

On November 26, 2014, the Delaware Chancery Court in Cigna Health and Life Insurance Company v. Audax Health Solutions, et al declined to enforce certain obligations that a buyer was attempting to impose on a target company’s stockholders as a condition to receipt of merger consideration. The transaction involved the acquisition by Optum Services, Inc. of Audax Health Services via the statutory merger provisions of Section 251 of the Delaware General Corporate Law (DGCL).

In the transaction, certain stockholders of Audax Health Services voted in favor of the merger and, prior to closing, signed support agreements containing a general release of claims (Release) and containing an agreement by such stockholders to certain indemnification obligations relating to breaches of representations, warranties and covenants (Indemnification Obligations).

For those stockholders of Audax Health Services who did not execute a support agreement prior to the closing, Optum attempted to condition their entitlement to receive merger consideration on their execution and delivery after the closing of a letter of transmittal that contained the Release and Indemnification Obligations provisions. Cigna, one of the former stockholders of Audax Health Services, challenged the enforceability of the Release and Indemnification Obligation.

The court analyzed the Release and Indemnification Obligations separately. In the case of the Release, the court refused to enforce the provision due to lack of consideration. Once the merger was consummated, Cigna was entitled to receive its share of the merger consideration, and at that point in time Optum did not have the right to impose new obligations on any stockholder of Audax Health Services without payment of additional consideration.

In the case of the Indemnification Obligations, the court analogized the indemnification provisions to a post-closing purchase price adjustment, or clawback, and considered whether a merger under Section 251 of the DGCL could, by its terms, require stockholders of the target corporation to give back or surrender merger consideration that they have already received.

Without ruling definitively on that question, the court concluded that in this particular case, the Indemnification Obligation could not be enforced because as written it allowed Optum to clawback all of the merger consideration, without limitation as to time or amount, and in so doing such requirement violated Section 251(b)(5) of the DGCL, which mandates that a merger agreement set forth a determinable amount of merger consideration.

It should be noted that the court did not rule that clawback provisions in merger agreements are per se unenforceable, however, until the law is more settled in this area, a buyer considering an acquisition and who wishes to impose obligations on the target corporation’s stockholders must consider alternative solutions when structuring its transaction. There are a number of these that can achieve similar results as a practical matter that we would be happy to discuss.

To read the court’s entire decision, please click here.