Private Equity

A common practice in private company mergers is to attempt to bind a selling company’s minority stockholders to certain obligations, such as indemnification obligations and releases, by including the acknowledgement of such obligations in the letter of transmittal that is signed as a condition to the receipt of the merger consideration in the transaction.  The Delaware Court of Chancery recently issued an opinion in Cigna and Life Insurance Company v. Audax Health Solutions, Inc. that has created some doubt about the enforceability of that practice.

In Cigna, the court scrutinized an attempt in a private company merger to impose various post-merger obligations on non-consenting stockholders of the selling company, including (i) a broad release of claims in favor of the acquiring company that was included only in the letter of transmittal and (ii) a post-closing “clawback” indemnification arrangement set forth in the merger agreement which was not subject to an identifiable escrow.  The court held that (i) the release obligation was unenforceable for lack of independent consideration given that the merger agreement provided no indication to the selling company stockholders that such a release would be a condition to payment of the merger consideration and (ii) the indemnification obligation was unenforceable because its structure, which potentially placed all of the merger consideration at risk for an unlimited period of time with respect to claims for breaches of certain fundamental representations and warranties, rendered the value of the merger consideration unknowable in violation of Section 251 of the Delaware General Corporation Law.  The court emphasized that its holding was limited solely to the combination of factors presented in the Cigna case and specifically highlighted that its opinion did not address other common methods of obligating the selling company stockholders to provide indemnification in a private company merger, including through an indemnity escrow.

There has been a great deal of (varying) reactions from corporate law practitioners who are reexamining their approach to private company mergers in light of the Cigna decision.  One simple solution may be to focus on properly drafting the “drag-along” provisions found in most stockholders agreements entered into in connection with private equity transactions and then requiring that the selling sponsor contractually agree to exercise its drag-along rights in connection with the merger transaction.  A well-drafted drag-along provision could provide the selling sponsor with the following rights to address the issues presented in the Cigna case:

• an acknowledgement by the minority stockholders that they will be obligated to make certain fundamental representations, to bear, on a pro rata basis, post-closing indemnification obligations, purchase price adjustment payment obligations and escrow contributions and to grant releases in favor of the buyer if those obligations are agreed to by the selling sponsor;
• the authorization of the selling sponsor to take all actions necessary or desirable to consummate the drag-along transaction, including authorizing the selling sponsor to serve as the representative of all minority stockholders in connection with the drag-along transaction; and
• the granting of a power-of-attorney in favor of the selling sponsor allowing the sponsor to sign documents on behalf of the minority stockholders to implement the foregoing.

If a selling sponsor negotiates drag-along rights with these protections at the time of its initial investment, it will be well-positioned in connection with an exit transaction to avoid the pitfalls highlighted in the Cigna case and to ensure a smooth exit process.