Chancery Court Rules That Pre-Closing Attorney Client Privilege Over Deal Related Communications Stays with Sellers

Doru Gavril and David Livshiz are partners and Scott Eisman is special counsel at Freshfields Bruckhaus Deringer LLP. This post is based on a Freshfields memorandum by Mr. Gavril, Mr. Livshiz, Mr. Eisman, Paul Humphreys, Umer Ali, and Hadar Tanne. This post is part of the Delaware law series; links to other posts in the series are available here.

The Delaware Court of Chancery (Vice Chancellor Zurn) recently held in DLO Enterprises, Inc. v. Innovative Chemical Products Group, LLC, 2020 WL 2844497 (Del. Ch. June 1, 2020), that the seller in an asset transaction retains attorney-client privilege over its pre-closing deal communications unless the asset purchase agreement explicitly provides otherwise. This rule, the court explained, contrasts with the default rule in a merger, where the privilege over the target’s pre-closing communications by operation of law, upon the effectiveness of the merger, vests in the surviving corporation (absent any contractual provision to the contrary). The court also observed that parties in an asset transaction can contract around the default rule for asset sales by specifying that the buyer acquires the privilege in whole or in part, or that the privilege is waived. While the DLO decision clarifies the default allocation of privilege in asset sale transactions, we do expect further litigation concerning the contractual language shifting the default privilege presumption. The decision also leaves open the treatment of attorney work product, which is not coextensive with the attorney-client privilege and which was not explicitly addressed in DLO.

Key Takeaways

  • The default rule in an asset purchase is that sellers retain privilege over their own pre‑closing deal communications unless the parties explicitly agree otherwise.
  • This rule differs from the default rule in a merger, where the surviving corporation acquires the privilege over the target’s pre-closing communications.
  • As with all default rules, the parties to the transaction may agree to alter these default rules through contract.
  • A seller in an asset sale might waive privilege over pre- and post-closing emails by transferring those email accounts to the buyer upon closing and continuing to use those transferred accounts after closing.

Background

In early 2018, Innovative Chemical Products Group, LLC and an affiliate (“Buyer”) bought substantially all of the assets composing the Arizona Polymer Flooring business (n.k.a. “DLO Enterprises” or “DLO” or “Seller”), a company that developed and sold adhesive products. The shareholders of DLO also happen to be employees who transferred to Buyer at closing of the transaction. The Delaware‑law governed purchase agreement specified that the Buyer acquired the right to waive attorney-client privilege and attorney-work-product protection “relating to” purchased assets and assumed liabilities, as defined in the agreement.

Soon after closing, that privilege provision became the focus of a dispute between the parties. The Buyer discovered that one of DLO’s business lines suffered from defects. The Buyer sued the Seller in Delaware Chancery Court, alleging that the Seller knew about the defects and knowingly misrepresented that DLO’s financial statements contained no undisclosed liabilities. During discovery, the Buyer sought to determine what the Seller knew about the defective product line, and the Seller withheld as privileged (1) deal-related attorney-client communications that remained in the Seller’s possession (the “Retained Communications”), and (2) communications from both before and after closing between the Seller and its deal counsel through email accounts transferred to the Buyer upon closing (the “Transferred Communications”). The Transferred Communications included post-closing communications with Seller’s deal counsel on company email accounts by one of the individuals who was a shareholder of Seller and who remained as an employee at DLO after the transaction closed.

Invoking Delaware case law on transfer of privilege, as well as the purchase agreement’s provision allowing the Buyer to waive privilege over certain communications, the Buyer moved to compel production of the withheld communications.

The Chancery Court’s Decision

Vice Chancellor Zurn ruled that privilege over the Retained Communications remained with the Seller. As to the Transferred Communications, the court suggested that the Seller might have waived privilege but could not decide the issue on the record before it. The court thus ordered supplemental briefing on waiver of privilege as to the Transferred Communications.

Retained Communications

The court held that, under Delaware law, privilege over pre-closing deal communications in an asset sale does not automatically transfer to the buyer of the subject assets upon closing. This rule stands in sharp contrast to the default rule for privilege in respect of deal communications in mergers.

As the court explained—and as prior Delaware decisions have held—DGCL § 259 provides a default rule for the transfer of privilege in a merger: “all property, rights, privileges, powers and franchises” become “the property of the surviving or resulting corporation.” So absent “an express carve out” in the merger agreement, “the privilege over all pre-merger communications—including those relating to the negotiation of the merger itself—passe[s] to the surviving corporation in the merger.” [1] Not so for asset purchases. In an asset purchase, the court held, the default rule is that the selling entity, at a minimum, retains the privilege over its pre-closing communications about retained assets and liabilities, and about the deal itself. As the court explained, no statute provides for the transfer of privilege over all pre-closing communications in an asset sale. And according to the court, such a sweeping rule would make little sense, given that the seller remains a going concern and needs the privilege to help “prosecute . . . and defend” claims concerning retained assets. The court also acknowledged, however, that parties to an asset purchase can modify the default privilege allocation by agreement.

The Buyer in DLO also argued that even if the privilege over pre-closing deal-related communications did not transfer to it automatically on closing, privilege was waived under the purchase agreement’s privilege-waiver provision, which gave the Buyer the right to waive privilege over communications concerning purchased assets and assumed liabilities. The court rejected the Buyer’s reading of the agreement’s privilege waiver provision. That provision did not apply to “Excluded Assets,” which included “the [sellers’] rights under or pursuant to th[e] Agreement.” Citing with approval prior case law interpreting similar language, the court concluded that “the pre-closing privilege over deal communications pertains to an Excluded Asset and therefore stays with sellers.”

One notable point about the limits of DLO: Although the decision establishes that privilege over pre‑closing deal communications and about assets retained by the seller remains with the seller by default, the opinion is silent on the default rule for pre‑closing privilege relating to assets purchased by the buyer. Because the purchase agreement explicitly transferred to Buyer the privilege related to the transferred assets, the court did not need to consider whether the privilege would have “followed” the assets even if the agreement had been silent on it. The decision thus leaves open the possibility that pre-closing privilege for communications relating to purchased assets automatically “follow” those assets to the buyer by default, rather than staying with the seller. It would not be surprising, however, if a court held that the privilege is not bundled with the purchased assets, absent explicit contractual provisions. The attorney-client privilege is tied not to a specific asset, but to the entity that receives the legal advice. The nature and the sensitivity of the privilege also favors requiring an express statement that a party intends to transfer it.

Regardless, DLO affirms the right of parties to contractually allocate privilege in asset sales over pre‑closing communications—a right that parties should exercise to clearly define who holds privilege post-closing over pre‑closing communications relating to the purchased assets. [2]

Transferred Communications

The decision also considered whether the Transferred Communications were privileged. Those communications consisted of emails in accounts that had been transferred to the Buyer as part of the transaction, including emails that had been pre-and post-closing. While the court hinted at the analysis applicable to each set documents, it requested additional briefing to determine whether privilege had been waived over both the pre-and post-closing communications.

The pre-closing communications had been conducted by certain of the shareholders of Seller in the context of their employment. The court suggested that the “inadvertent production” standard should apply to determine whether the Seller had waived privilege by transferring these emails to the Buyer, but reserved decision on the appropriate standard.

The court held that a different test would apply to the post-closing communications. Because those communications had been conducted by the individuals, who were shareholders of the Seller, after they started working for the Buyer, the court applied the employee-expectation-of-privacy test to determine whether waiver had occurred through disclosure to the Buyer. [3] That test asks whether (1) the corporation has a policy of banning personal email use, (2) the corporation monitors employees’ computer or email, (3) any third parties have a right to access employees’ computer or emails, and (4) the corporation notified the employee (or the employee otherwise knew) of the corporation’s use and monitoring policies. This test, the court noted, can be overridden by statute. So while the court determined that a majority of factors leaned toward waiver of privilege, it requested additional briefing to determine whether an overriding statute protecting employees’ documents against disclosure.

Finally, the court chided the Buyer’s counsel for inappropriately reviewing the content of the Transferred Communications, emphasizing that the Buyer should have segregated and abstained from reviewing the documents upon becoming aware that they possessed potentially privileged material.

Unanswered Questions

What about work product? This is not a hypothetical question, nor does it concern a corner case. In circumstances preceding a sale of assets, documents concerning defects in product or business lines could readily be protected by the work-product doctrine.

The Court’s ruling in DLO did not distinguish between the work-product doctrine and attorney-client privilege. The Delaware Supreme Court, however, has long made it clear that “[w]aiver of the attorney-client privilege does not automatically relinquish the protection provided by the work product doctrine.” Tackett v. State Farm Fire & Casualty Ins. Co., 653 A.2d 254, 260 (Del. 1995). Indeed, “[u]nlike the attorney-client privilege, the work product doctrine is intended to protect ‘the privacy of lawyers in their work and encourage the freedom of lawyers from interference in the task of preparing their clients’ cases for trial.’” Id. (citation omitted).

Not only are work product and attorney-client privilege not coextensive, but the laws of different states vary substantially on what constitutes work product. For example, California defines attorney work product by statute and—unlike most jurisdictions, including Delaware and federal courts—does not require the anticipation of legal proceedings for the protection to attach. See Cal. Code Civ. P. § 2018.030. A court evaluating if a document is protected under the work-product doctrine may need to weigh carefully which law should govern: forum law (which applies to procedural issues), contract law (which the parties may specify in an attempt to define the work product), or the law of the state where the work product was created (which may apply absent a contractual selection by the parties). [4]

The distinction between the attorney-client privilege and work product becomes even more significant in the context of a transfer of assets, given that the owners of the privilege and of the work-product protection are different. While the client owns the privilege, work product belongs to the lawyer. Reese v. Klair, 1985 Del. Ch. LEXIS 403, *17 (1985) (“When dealing with attorney work product immunity, the privilege belongs to the attorney rather than the client as opposed to the privilege for attorney-client confidential communication which belongs to the client.”); accord State Comp. Ins. Fund v. Super. Ct., 91 Cal. App. 4th 1080, 1091 (2001) (“The attorney is the exclusive holder of the [work product].”).

Absent consent of the lawyer, can the client sell the work product as an asset, when it does not even own it in the first place? These questions are left unanswered in Vice Chancellor’s Zurn’s ruling, and will likely require further litigation to elucidate in the absence of explicit contractual provisions.

Impact

  • DLO underscores the distinction under Delaware law between privilege transfer in asset purchases and privilege transfer in mergers. Parties conducting Delaware-law-governed mergers should expect that attorney-client privilege and work product in target company communications will vest in the surviving company at the effective time of the merger. Parties conducting Delaware-law-governed asset purchases should expect that, unless altered by the terms of the acquisition agreement, the attorney-client privilege and work product over deal communications and about any retained assets will remain with the seller.
  • Parties remain free to contract around the default rules. If they plan to depart from the default rules, they should work closely with their attorneys (M&A lawyers and litigators) to ensure that the merger or asset-purchase agreement clearly delineates which privileges transfer to the buyer and which are retained by the seller.
  • As DLO recognized, default rules on transfer of privilege differ across jurisdictions in material respects. Parties and their attorneys should carefully review the case law in the jurisdiction whose law governs their agreement.
  • In an asset sale, when transferring email accounts and emails, sellers should be careful not to transfer pre-closing privileged communications. Because of the expense and effort required to identify privileged communications in emails, parties are well-advised to be explicit about who retains/acquires privilege, including by incorporating the default rules as contractual provisions in the acquisition agreement.
  • Individual sellers who will remain as employees of the business being sold should be aware that their post-closing emails with their transaction counsel may not be privileged from disclosure to the buyer (i.e., their post-closing employer)—especially if the employees can reasonably expect that their employer will monitor or otherwise access their emails. Best practice will likely be to abstain from using transferred email accounts for deal communications that employees may want to claim are privileged as against their employer.
  • Upon becoming aware of potentially privileged material in their possession, counsel should segregate and abstain from reviewing any such material pending the resolution of their privileged status.

Endnotes

1Great Hill Equity Partners IV, LP v. SIG Growth Equity Fund I, LLLP, 80 A.3d 155, 162 (Del. Ch. 2013).(go back)

2It is not uncommon in going concern sales structured as an asset sale (like DLO) for the parties to define legal privilege as a “purchased asset”. Privilege in deal communications is also sometimes defined as an “excluded asset” in asset purchase agreements. Similarly, most M&A agreements have language stating that the buyer will acquire “all right, title and interest in and to” the purchased assets, which is potentially an argument in favor of the privilege “following” the purchased assets (though, as DLO demonstrates, parties to an asset sale would be better served to be more explicit in the deal documentation).(go back)

3In re Asia Global Crossing, Ltd., 322 B.R. 247, 257 (Bankr. S.D.N.Y. Mar. 21, 2005).(go back)

4Delaware Rule of Evidence 510, governing waiver, defines work product as “the protection that applicable law provides for documents and tangible things (or their intangible equivalents) prepared in anticipation of litigation or for trial.” That definition, however, governs what is waived under Delaware evidentiary rules, not what is protected under the applicable laws of other states.(go back)

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