In a rare decision involving unusual facts, the Delaware Court of Chancery held that a buyer (Energy Transfer Equity, L.P.) had the right to terminate a signed merger agreement with its target (The Williams Companies, Inc.) that Energy Transfer no longer wished to close due to the unexpected decline in the energy markets. Fortuitously, Energy Transfer’s outside tax counsel was no longer able to deliver a tax opinion that was a required condition to closing, a fact which the court held gave Energy Transfer the ability to walk away from the deal.
A condition to each party’s obligation to close the transaction was the receipt of an opinion from buyer’s tax counsel, Latham & Watkins, that an aspect of the transaction “should” qualify as a tax-free exchange. As it turned out, Latham would not give the tax opinion because the value of certain assets had declined so much after signing that its initial analysis no longer held true. Upholding Delaware’s strong contractarian policy, the court found that the parties had mutually agreed to give the buyer the right to not close if Latham did not provide the tax opinion. Therefore, although the buyer’s primary motive for terminating the merger agreement was not for tax reasons, the court concluded that Energy Transfer could terminate based on the failure to meet this condition. The court further found that Energy Transfer did not breach its covenant to use “commercially reasonable efforts” to obtain the Latham tax opinion although its head of tax pointed out the change in facts to Latham which set off the course of events that led to the deal’s implosion.
The decision is consistent with recent Delaware decisions in which the court has interpreted the efforts covenant narrowly. However, because the architecture in merger agreements is designed to give parties certainty that a signed deal will close barring extraordinary conditions, the outcome and prominence of this failed deal may cause deal counsel to rethink the potential consequences and optionality of requiring opinions that are delivered by a party’s own deal counsel as a condition to closing.
Background. Energy Transfer Equity, L.P. and The Williams Companies, Inc. are involved in the gas pipeline business. The mutually agreed upon transaction structure was designed to accommodate Williams’ desire to have its stockholders receive cash and publicly traded common stock (as opposed to partnership interests) in the merger. In the agreed upon structure, Williams would merge with ETC, a new, wholly owned subsidiary of Energy Transfer, and Williams’ shareholders would receive: (1) ETC shares representing 81% of ETC, (2) $6.05 billion in cash and (3) certain contingent consideration rights. The transaction would also involve two “legs” between ETC and Energy Transfer. In the “cash” leg, Energy Transfer would transfer $6.05 billion to ETC in exchange for a fixed 19% of ETC’s shares and ETC would distribute the cash to the former Williams stockholders. In the “contribution” leg, ETC would contribute the former Williams assets to Energy Transfer in exchange for Class E units of Energy Transfer in a transaction intended to qualify as a tax-free exchange of value for value under Section 721 of the Internal Revenue Code. (Under Section 721, a contribution of property for a partnership interest of equivalent value is generally not a taxable event.)
When the merger agreement was signed, Latham believed it could issue the required tax opinion (and tax counsel for Williams had “no concern” about the delivery of the opinion). However, the merger agreement contained a reciprocal closing condition that each of ETC and Williams shall have received a tax opinion from only Latham that the contribution of the former Williams assets from ETC to Energy Transfer in exchange for Class E units of Energy Transfer “should qualify as an exchange to which Section 721(a) of the [Internal Revenue Code] applies.”
After signing the merger agreement, the energy markets experienced a precipitous decline and Energy Transfer no longer wanted to close the merger. Energy Transfer’s head of tax, Brad Whitehurst, raised concerns that the tax-free nature of the exchange of Williams’ former assets for partnership units could be jeopardized due to the decline in value of both the Energy Transfer units and the ETC shares. Whitehurst was concerned that because the 19% of ETC to be received by Energy Transfer was worth about $4 billion less than the $6.05 billion of cash to be paid by Energy Transfer for that stock, the IRS would treat the excess amount of cash instead as a partial payment by Energy Transfer for the Williams assets that were to be contributed by ETC to Energy Transfer in exchange for the Energy Transfer units in the “contribution” leg, resulting in about $4 billion of taxable gain to ETC. After considering the issue, Latham agreed and stated that it would not opine that the transaction “should qualify” as a tax-free exchange under Section 721; a second tax counsel subsequently retained by Energy Transfer agreed with that conclusion (albeit for a different reason). Williams’ tax attorneys from Cravath, Swaine & Moore fervently disagreed and provided support for Williams’ assertion that the IRS would view ETC as merely a conduit for the passage of cash to Williams’ stockholders and that the contribution transaction should be deemed tax free. A second tax advisor to Williams, however, said it would be difficult to give a “should” opinion but eventually concluded that it could give a “weak-should” opinion.
Citing the failure of a condition precedent, Energy Transfer then asserted its right to terminate the merger on the drop-dead date while Williams sought a declaration that Energy Transfer had breached the merger agreement and requested a permanent injunction to preclude Energy Transfer from terminating the merger agreement on account of the breach.
Energy Transfer Did Not Breach its Covenant or Representations
In this action, Williams claimed that Energy Transfer was so desperate to avoid completing the deal that it acted in a way to preclude Latham from rendering the Section 721 opinion in violation of its covenant to use “commercially reasonable efforts.” The court disagreed, finding that Energy Transfer did not materially breach the covenant. It held that agreeing to take “commercially reasonable efforts,” meant to act “objectively reasonable” in the context. The court concluded that Energy Transfer satisfied this covenant because there was nothing more that it could have done to change the fact that Latham could not give the opinion. It found that the fact that Whitehurst brought the potential issues to the table after it became apparent that the client wished to terminate the deal did not influence Latham’s conclusion. Instead, the court found that Latham would have reached the conclusion in any event. Ultimately, the court found that the closing condition was based on Latham’s subjective opinion that the transaction “should qualify” for tax-free treatment and that Latham reached its conclusion independently and in good faith. It noted that Latham devoted over 1000 hours to its analysis and reached its conclusion despite significant risk to its reputation. Based on these findings, the court concluded that Energy Transfer did not breach its covenant.
The court distinguished the facts from those in Huntsman v. Hexion (2008), a prominent decision that came out during the financial crisis when deals were commonly being renegotiated due to buyers’ inability to obtain debt financing. In Hexion, the court held that the buyer breached its “reasonable best efforts” covenant when it knowingly and actively obtained an opinion that the combined entity would be insolvent for the specific purpose of scuttling its financing. Here, unlike in Hexion, the court found that Energy Transfer did not take any affirmative acts to coerce or mislead Latham to prevent issuance of the tax opinion.
The court further held that Energy Transfer did not breach its representations and warranties because Energy Transfer did not misrepresent facts or withhold information that would have manipulated Latham’s knowledge or ability to render the tax opinion, even though Latham’s analysis had changed.
- Limiting optionality. In this case, the court held that because the parties assigned the responsibility for the opinion solely to Latham, it only needed to determine whether Latham determined in good faith that it could not issue the required opinion. More commonly, the tax opinion condition is drafted to require each party’s tax counsel to deliver an opinion to its client as a condition to closing for that party. In either case, and even though the facts here are highly unusual, the decision may cause deal parties to rethink the potential optionality of allowing a party to walk away from the deal based on the inability of its own counsel to deliver an opinion. For example, the court suggested the possibility of requiring objective standards to be used, such as picking an independent third party (e.g., an academic) to determine the tax treatment of the transaction in question. The condition could also be drafted to add dispute resolution procedures or other objective processes if the lawyers disagree.
- Choice of words matter. As the court noted, tax opinion closing conditions can be drafted based on various levels of certainty. Although the court did not review Latham’s decision on a substantive basis, it did parse the language to determine if Latham acted in good faith when it concluded that it could not give a should-level opinion (contrasted to “will” or “more likely than not”). While there may already be consensus among tax experts on what these phrases mean as a term of art, the decision offers written guidance and suggests that a court will apply the industry-meaning ascribed to these terms. Citing the testimony of tax lawyers on both sides, the court noted that “more likely than not” means “at least a 51% chance”; “should” means “quite likely that the decision will be upheld” (and that “there is very good supporting case law”); and “will” means that the opinion is “virtually certain to be upheld.”
- Efforts levels may be illusory. As we have noted before, the term “commercially reasonable efforts” is not easily defined. While the court noted that the standard requires an objective, good faith standard, the decision reinforces that there is no clear meaning of that phrase. Parties that wish to require a higher level of effort in order to improve deal certainty may want to add more specific language in the contract beyond the usual “reasonable best efforts,” or “commercially reasonable efforts” because recent rulings have shown that the current efforts levels may actually be illusory. For example, in Hexion and in Apollo Tyres v. Cooper (Del. Ch. 2013), even though the standard used was the higher “reasonable best efforts,” language, the court applied the same meaning to that standard — “good faith in the context of the contract” – that was used in this deal.
As a general observation, there is increasing focus by regulators on tax-driven deal structures. Proposed inversion transactions have led to recently proposed Treasury and SEC rules designed to stem the tide of inversions and recently the Department of the Treasury proposed rules limiting the ability of companies to conduct a tax-free spin-off if the “active trade or business” of the distributing corporation or the corporation that is distributed is relatively small in relation to its other assets. These changes have already stymied a number of prominently announced deals (Yahoo/Alibaba (spinoff) and Shire/AbbVie, Allergan/Pfizer (inversions)). In light of this attention, it will be interesting to see whether parties will focus on tax opinion conditions more specifically or approach deals on the margin more conservatively, as a general matter.
Shortly after the ruling, the case was appealed. It is currently being reviewed by the Delaware Supreme Court. We will keep you posted on any developments.
See The Williams Companies, Inc. v. Energy Transfer Equity, L.P. , C.A. No. 12168-VCG (June 24, 2016)