Con Ed Uncertainty: Court of Chancery Questions Enforceability of Merger Agreement Provisions Allowing Target to Seek Lost Merger Premium

In an October 31, 2023 decision sure to spook practitioners, the Court of Chancery called into doubt the enforceability of “Con Ed provisions.”  Con Ed provisions, so-named for the 2005 Second Circuit decision prohibiting stockholders from pursuing a $1.2 billion merger premium damages claim, create a path for the target’s recovery of lost merger premium if the buyer breaches and a deal fails.

Chancellor McCormick’s decision – the first to consider the enforceability of such provisions, albeit in an unusual procedural posture – may lead deal practitioners to revisit them.  Until market practice settles on new provisions or mechanisms to protect this important sell-side protection and eliminate the uncertainty this decision creates, dealmakers will be left considering whether to (i) formally seek appointment of the target as its stockholders’ agent to pursue a lost-premium damages claim or (ii) potentially allocate to stockholders more explicit rights as third-party beneficiaries, running the risk of disproportionately enriching would-be plaintiffs’ counsel and proliferating litigation.

Background

The Crispo v. Musk decision is yet another gift-qua-decision arising from the Twitter-Musk dispute.  A stockholder plaintiff sued Elon Musk and related entities for breaching fiduciary duties allegedly owed as a controller and for breaching the merger agreement (before Musk changed course and agreed to close).  After dismissing the fiduciary duty claim, the Court considered whether the stockholder had standing to sue for lost-premium damages and requested supplemental briefing as to whether the stockholder could pursue claims based on the merger agreement’s Con Ed provision, which provided that in the event of breach, the buyer would be liable for:

“The benefits of the transactions contemplated by this Agreement lost by the Company’s stockholders . . . taking into consideration all relevant matters, including lost stockholder premium.”

The agreement also, however, expressly disclaimed third-party beneficiaries (with specific carveouts inapplicable here).

Months later, after the deal closed (and with no supplemental briefing having been filed), the stockholder filed a “mootness fee” petition, seeking $3 million and claiming that the stockholder litigation played a role in Musk’s decision to close the deal.  This decision analyzed whether the stockholder’s claims were “meritorious when filed,” which as a threshold matter required showing that the stockholder had standing to pursue the claims in the first place.

The Court of Chancery’s Decision:  Con Ed Provisions Potentially Unenforceable

The Second Circuit’s 2005 Con Ed decision held that a broad prohibition on third-party beneficiary status precluded stockholders from seeking to enforce the merger agreement and pursue a claim for lost-premium damages.  As Chancellor McCormick explained, this “came as a surprise” to practitioners and created an imbalance between buyer and the target.  As one treatise put it, this would shift “the balance of leverage in any MAC, renegotiation, or settlement into an ‘option’ deal such that the buyer could walk away with little consequence.”

“Con Ed provisions” were thus born.  The Court explained that three forms took shape; all sought to make the buyer liable for lost stockholder premium in the event of deal failure emanating from a buy-side breach:

1. Expressly provide stockholders with third-party beneficiary status to pursue claims under the merger agreement. But the Court noted that this creates problems of its own (g., it could proliferate litigation against buyers and interfere with the seller board’s ability to “control the litigation asset and secure a favorable outcome”).
2. Allow the target, as agent, to recover lost-premium damages for its stockholders.
3. Define damages recoverable by the target company to include lost merger premium (the “Defined Damages Provision”).

The third was at issue in Crispo.  The Court held that (i) the Defined Damages Provision and (ii) the term disclaiming third-party beneficiaries could be harmonized together in two ways.

First, the Court reasoned that a Defined Damages Provision could be interpreted to be unenforceable:

• Contractual damages provisions may not create a penalty – such a term is unenforceable as a matter of contract law. Stated differently, a contracting party may recover only amounts that match benefits it was to have received under the contract.
• Because the target company does not directly receive merger consideration, and payment goes directly to stockholders, the Court reasoned that the Defined Damages Provision could not be enforced, because the entity doing the enforcing (the target) had no entitlement to the premium being sought.
• Therefore, lost-premium damages could be recovered only if the agreement granted third-party beneficiary status to the stockholders who were to receive the premium. Because the merger agreement here expressly disclaimed third-party beneficiaries, the lost-premium amount could not be recovered.

But the analysis did not end there – as the Court noted, this would violate a “cardinal rule of contract construction,” namely, that “a court should give effect to all contract provisions.”

The Court thus turned to a second plausible interpretation: that the merger agreement could be read to grant “stockholders third-party beneficiary status that vest[s] in extremely narrow circumstances and for the limited purpose of seeking lost-premium damages.”

• Because Con Ed provisions exist to remedy lost premium after the merger has failed, such provisions could not confer standing “while the remedy of specific performance is still available.” Thus, the Court found that the merger agreement could potentially be interpreted to grant a stockholder a limited right to pursue lost-premium damages, under narrowly defined circumstances, which would run “concurrent to the target’s right to pursue damages under the merger agreement.”
• As the Court noted, any such claims filed by stockholders would be governed by the merger agreement’s forum selection provision, and thus a single court could consolidate the resulting lawsuits.

Takeaways

Con Ed provisions play a critical role in allocating power between buyer and seller.  The market will need to adjust quickly in the wake of Crispo and identify mechanisms to address the enforceability questions that the Court identified.

In addition, the many practitioners who have historically not explicitly addressed lost-premium damages in merger agreements subject to Delaware law based on the belief that the maximum damages permitted by law arguably contemplated lost-premium damages may want to reconsider their approach.  Potential means of addressing Crispo include:

• Explicit Third-Party Beneficiary Status: Drafters could make the Court’s second reading explicit and make target stockholders third-party beneficiaries for the limited purpose of pursuing lost-premium damages should specific performance be unavailable or not pursued by the target company.
• Formally Appoint the Target as Agent: Rather than purporting to unilaterally appoint the target as agent – which the Court suggested in dicta lacked a “legal basis” – take steps to formalize the arrangement.
  • Charter provision: As the Court suggested, the target company could seek to amend its charter to include a provision “designating the company as the stockholders’ agent for the purpose of recovering lost-premium damages after [a] failed sale.”  Although newly-public companies could include such provisions in their charters, it is not clear that existing public companies would seek approval for such an amendment on a “clear day” or whether such approval would need to precede execution of a merger agreement.
  • Stockholder vote: Stockholders could be asked, when voting on the merger, also to vote to make the target their agent.  It is not clear that this possibility addresses the Court’s concern, however, because unanimity will never exist in the context of a public company stockholder vote.  Failing to obtain the consent of all stockholders thus arguably raises the same issue the Court identified: a failure to obtain the principal’s consent to the target’s appointment as agent.

There will be pros and cons to all efforts to address these questions, including that they, too, are untested by the courts.

Other portions of the Court’s decision – in dicta – raise more questions and concerns.  For example, as noted above, in discussing the prospect of a provision appointing the target as “agent” (a provision not at issue in the case), the Court suggested there is “no legal basis for allowing one contracting party to unilaterally and irrevocably appoint itself as agent for a non-party for the purposes of controlling that party’s rights.”  The corresponding footnote relies exclusively on a treatise, “noting that it was unclear whether a court would allow a target company to irrevocably appoint itself as an agent of its shareholders….”

But it is common for an individual or entity to act for stockholders in connection with a merger.  E.g., Appriva S’holder Litig. Co., LLC v. EV3, Inc., 937 A.2d 1275, 1280 (Del. 2007) (“Under the Merger Agreement . . . Lesh and another Appriva shareholder… were appointed the ‘Shareholders’ Agent’ by the shareholders of Appriva, to jointly act as their agent and attorney in fact.”); In re Openlane, Inc., 2011 WL 4599662, at *3 (Del. Ch. Sept. 30, 2011) (merger agreement included provisions appointing third party as “agent and attorney in fact for and on behalf of each of [OPENLANE’s shareholders]”; the agent was a party to an escrow agreement pursuant to which it acted on behalf of the shareholders after the merger; escrow agreement “was within the Board’s decision-making authority.”); 8 Del. C. § 251(b) (permitting inclusion of merger agreement terms including “other details or provisions as are deemed desirable”).  This seems facially within the bounds of Section 251 itself, which permits agreement terms to be “made dependent on facts ascertainable outside of such agreement”; “facts” is defined to include “the occurrence of any event, including a determination or action by any person or body, including the corporation.”  But the dicta in Crispo would suggest that absent unanimous stockholder assent to a merger agreement (or adoption of a charter provision providing the same), the appointment of any such representative is subject to question.

Further, the decision between (1) making stockholders third-party beneficiaries and (2) appointing the target as agent to pursue a damages claim raises other considerations, including the identity of those pursuing the claim.

Stockholders pursuing claims as beneficiaries will in all likelihood be represented by class counsel operating on a contingency fee basis.  Counsel will, as a practical matter, seek a substantial portion of any successful case or settlement.  (For example, in a recent settlement, plaintiff’s counsel was awarded $266.7 million of a $1 billion dollar award, more than 26% of the settlement amount.)  Corporate counsel, by contrast, often operate on an hourly basis; success fees, if agreed, are often far smaller than the amounts awarded to plaintiff’s counsel.  Shifting the recovery right from the target company to stockholders, therefore, likely means that an increased proportion of any recovery will be taken out of the target’s stockholders’ pockets – and paid instead to lawyers.  This also raises practical problems, including (i) the inefficiency of different counsel litigating the damages claim than the underlying equitable claim and (ii) that pursuit of the claim by stockholders’ counsel will be inhibited by a lack of access to privileged information that would be available to company counsel.

The market and M&A bar will undoubtedly adjust to Crispo; the specifics remain unclear.  It is also possible that the Delaware General Assembly takes action in the face of this decision.  For now, particularly on the sell side, it will be critical to consider and work through with counsel the risks that Crispo presents and potential solutions.

This post is as of the posting date stated above. Sidley Austin LLP assumes no duty to update this post or post about any subsequent developments having a bearing on this post.