ConEd Is Not Dead In Delaware

This is the price paid for allowing our hopes, rather than established law, to guide public merger agreement drafting for the last 18 years.  Con Edison v Northeast Utilities[1], a 2005 Second Circuit decision regarding a New York law governed merger agreement, found that, absent clear contractual language to the contrary, a target company could not collect lost shareholder premium as damages for the breach of a merger agreement. ConEd caused quite a stir in public M&A circles, with some asserting that it caused every public merger agreement to be converted into a mere option agreement, where, if the buyer did not wish to close, it had only to pay the target’s out-of-pocket costs. This may have been a bit extreme, but given how infrequently specific performance has been ordered to remedy a failure to close, it probably was not far off the mark.

We may have been lulled by the fact that the decision and merger agreement were a product of New York, rather than Delaware, law. Or by then Vice Chancellor Strine’s extra-judicial assurances that “no third party beneficiary” language in merger agreements “was not designed to deprive the corporation of remedies pursued in good faith by the directors on behalf of the stockholders, but [rather] designed to deal with the cacophony that could arise with individual shareholders trying to enforce a contractual right.”[2]  But, it turns out, all of the various clever drafting fixes practitioners have been fighting over for the last 18 years failed their first judicial test since ConEd.  In other words, your merger agreement may be an option agreement.

Chancellor McCormick, in her recent decision in Crispo v. Musk et al,[3] efficiently describes and dismisses the three main approaches to “ConEd language”.

The first approach “was to expressly provide shareholders with [direct] third-party beneficiary status.”[4] To be fair, Chancellor McCormick did not have to dismiss this language, as the prospect of appointing thousands of public stockholders as litigants in a failed merger would be daunting to both target (which would presumably wish to preserve to itself the right to control the litigation and any settlement) and buyer (which would have no stomach for dealing with multiple class action attorneys in the event any breach of the merger agreement could be alleged).

On to the (previously) more viable approaches.

The second approach was to “make the target the agent for recovering damages on behalf of its stockholders.”[5] This approach, Chancellor McCormick noted, rests on “shaky ground,” as there is “no legal basis for allowing one contracting party to unilaterally and irrevocably appoint itself as an agent for a non-party for the purpose of controlling that [non-]party’s rights.”[6] This approach is not actually at issue in Crispo, so the statement is dicta, but it seems hard to argue with as matter of basic agency law, and it is very discouraging dicta for those hoping to take the second approach.

The Chancellor in a footnote offers a ray of hope by noting that a charter amendment could permit the target to act as the stockholders’ agent in collecting lost stockholder premia. While at first blush one might think that this solution could be implemented seamlessly at the time of a merger vote, there are three issues with that approach.  First, both parties would be at risk of a breach (or alleged breach) prior to the vote, potentially unleashing during that period the parade of horribles that arise when stockholders are given directly exerciseable third party beneficiary rights. Second, in a tender offer, there typically would be no stockholders meeting scheduled at which a charter amendment could be approved. Accordingly, the charter amendment would preferably be in place before any merger agreement is entered into – meaning that ISS and Glass Lewis may have to get on board pretty quickly with what should prove a very popular proposed charter amendment. (In a macro sense, it might be easier to move the Delaware legislature to action than to have hundreds of new stockholder proposals to evaluate and vote on.)

Finally, there is a technical problem that the charter amendment would need to address – the fact that damages typically are thought to accrue at the time of the breach, while damages would not be paid until a much later time, when the target would have a different stockholder base. So the charter amendment would need to establish whether any damages collected would need to be distributed to stockholders, and either provide a mechanism for damages to be distributed to the stockholders who were stockholders at the time of the breach, or, more likely, establish that third party beneficiary claims accruing to the stockholders at the time of the breach would be deemed transferred along with any stock transfer.

The third approach is “to define damages resulting from the breach in terms of lost premia.”[7] In this approach, stockholders are not granted third-party beneficiary status, but rather damages of the target are defined “by reference to its shareholders’ lost merger premium or to the ‘benefit of the bargain’ lost by its shareholders.”[8]  This is the approach that was at issue in Crispo.

Unfortunately for fans of this approach, Chancellor McCormick notes that because the lost premia “language was untested . . . the parties took the risk that the provision would be unenforceable.”[9]  And, indeed, in testing the “lost premia” language in Crispo, Chancellor McCormick found that the language was either (i) completely unenforceable (on the fundamental ConEd grounds that where a target (as opposed to its stockholders) has no entitlement to a premium if the deal closes, the target has no entitlement to lost-premium damages if the deal busts), or (ii) enforceable only if the target has exhausted or abandoned a specific performance remedy. This second interpretation may give added in terrorem incentive to a target’s specific enforcement remedy by making the alternative to specific performance a battle with thousands of shareholders and their various counsel, but, like the first alternative, this interpretation does not allow the target to collect “lost premia” damages – making a satisfactory monetary settlement difficult to achieve.

While long ago one might have hoped that “a court, in recognition of the role of mergers under corporate law, would permit parties to a merger agreement to agree that losses suffered by target shareholders should be taken into account in determining damages to target, without creating a potential collective action problem by naming the shareholders as third-party beneficiaries,”[10] nobody gets everything they hope for. So, we are back to the drawing board, perhaps with greater urgency than when ConEd was just a New York law problem.

There have been rumblings that a liquidated damages alternative to “lost premia” language might provide some comfort to target companies, but liquidated damages are themselves typically limited to the parties’ best estimate of damages to the parties – and again, in a typical merger agreement, there are very limited damages to the target itself. Target companies value the “lost premia” language in part because it provides for a scary, if undefined, number – an estimate of damages to the target, no matter how exaggerated, is unlikely to be as scary. The claim to significant liquidated damages could perhaps be bolstered if the target had an option to convert a significant percentage of the merger consideration payable to stockholders instead into a direct cash payment to the target – an option that, for tax reasons, would never be exercised in the absence of a dispute over closing. This option would allow the target to overcome the fundamental ConEd issue – that no damages to the target itself arise as a result of a failed closing.

In any event, there will no doubt be many solutions proposed, and perhaps many charters amended, over the next several months as practitioners come to grips with the fact that they have not in fact solved the ConEd riddle.

Endnotes