SAM GOODMAN—In a highly anticipated decision on a contested merger agreement, the Delaware Supreme Court affirmed the Delaware Court of Chancery’s ruling that acquiror Energy Transfer Equity L.P. (“ETE”) did not breach its agreement to merge with the Williams Companies, Inc. (“Williams”) when ETE terminated the merger agreement because its counsel was unwilling to deliver a tax opinion that was a condition to closing. This dispute—and the Delaware Supreme Court’s ruling—highlight that closing conditions included to offer a party protection can sometimes add to deal risk when the other party no longer wants to close the deal. Parties should seek to understand the risks of non-satisfaction of closing conditions and should evaluate whether the risk of failing to satisfy a closing condition outweighs the usefulness of including the condition, particularly with regard to tax opinions.
The ETE/Williams Merger
ETE and Williams, two publicly-traded oil and gas pipeline operators, entered into a complex, tax-sensitive merger agreement in September 2015. Under the terms of the merger agreement, ETE would create a Delaware limited partnership, which would then merge with Williams and remain the surviving entity. The agreement was structured to cater to Williams’ desire for its stockholders to remain holders of publicly traded stock, as opposed to less liquid partnership units. It contemplated two transactions: 1) a “cash transaction,” in which ETE acquired 19% of Williams’ stock in exchange for $6.05 billion in cash, and 2) a “contribution transaction,” in which ETE acquired all of Williams’ assets in exchange for a fixed number of partnership units in ETE.
In order for the merger to be economically feasible, the “contribution transaction” would need to qualify as a tax-free contribution under Section 721 of the Internal Revenue Code. Critically, the merger agreement provided that the parties’ obligation to close was conditioned upon ETE’s outside counsel issuing a tax opinion that the contribution transaction “should” qualify as tax-free under Section 721. Both ETE and Williams 1) represented that they knew of no facts that would reasonably be expected to prevent the contribution transaction from being tax-free and 2) covenanted to use “commercially reasonable efforts” to obtain the tax opinion and “reasonable best efforts” to consummate the transaction. While the agreement required Williams to pay a termination fee if it decided to terminate the merger, ETE did not have a comparable termination provision and could instead rely on the closing conditions (including the tax opinion) in relation to its obligation to close.
After signing but before closing, the price of oil and natural gas declined significantly, and the value of Williams’ assets similarly declined. ETE stood to receive partnership shares that were worth $4 billion less than the $6 billion it was obligated to pay to Williams. In short, the transaction was no longer financially desirable to ETE and ETE wanted out. ETE’s senior tax executive had what the Court of Chancery described as an “epiphany,” and raised concerns with ETE’s outside counsel that the transaction might be characterized as a “disguised sale” under the Internal Revenue Code if the excess $4 billion was treated as consideration for the Williams assets (in which case, the transaction would not qualify as tax-free). Although ETE’s outside counsel believed at signing that it could deliver the required tax opinion, it ultimately concluded that it could not deliver the opinion and ETE refused to close. Williams filed a lawsuit in the Delaware Court of Chancery in an attempt to force ETE to close the transaction, but the court sided with ETE. ETE quickly terminated the agreement after passing the “outside date.”
The Delaware Supreme Court’s decision
The Delaware Supreme Court affirmed the Court of Chancery in finding that ETE did not breach the merger agreement, but on different grounds. The Court explained that Williams had the burden of proving that ETE breached its covenants to use “commercially reasonable efforts” to obtain the tax opinion and “reasonable best efforts” to close the transaction. If Williams was able to meet that burden, the burden would shift to ETE to show that “the breach did not materially contribute to the failure of the transaction.” Avoiding the issue of whether ETE had actually breached its affirmative covenants, the Court concluded that ETE met its burden by showing the record contained no indication that the action or inaction of the partnership (other than drawing outside counsel’s attention to the tax problem) materially contributed to the firm’s inability to deliver the tax opinion.
Deal parties include closing conditions to mitigate risk; they want to be able to walk away from the deal if they are not getting the benefit of their bargain. Customary closing conditions, such as tax opinions, are often used to protect against identified risks, including the risk of a change in law or relevant facts. However, the benefits of including closing conditions are thwarted (and deal risk may increase) when a party has not assessed the degree of risk associated with closing the transaction. When negotiating closing conditions, parties should consider and balance the relative risk of non-satisfaction of each closing condition in relation to the utility of including the condition. Even with customary closing conditions, the transaction’s context is key; these considerations may be of particular importance when there are volatile market conditions, the transaction is complex or contains novel structural elements, or the negotiated conditions are somewhat within the control of the other party.
The following are features that deal parties have included or may want to include in order to decrease the risk of tax opinion closing conditions in response to the ETE-Williams decision:
- Ask for the bare essentials:
- Do not include a tax opinion closing condition
- Restrict the scope of bases for which a party would not be obligated to close to legally-required approvals that are not obtained or breach of covenants that result in a material adverse effect
- Restrict the scope of the opinion: Limit the scope of the tax opinion to no change in law that would impact the tax opinion or no change in facts that are critical to issuance of the tax opinion
- Show your cards early: Require that the form of the tax opinion and/or representation letter be delivered at signing, instead of at closing (note that this does not protect the parties from post-signing factual changes that could impact the tax outcome)
- Shift the risk: Require that target’s (rather than buyer’s) tax counsel provide the tax opinion
- Reinforce and clarify:
- Include language in the agreement that reflects the parties’ commitment to closing and requests that the court interpret the agreement’s provisions in light of the parties’ intent to close if a dispute arises
- Specify steps that the parties must take as part of the contractually-mandated standard of efforts to satisfy the conditions to closing
- Covenant to use reasonable best efforts to restructure the transaction if the tax opinion cannot be issued
- Waive the tax opinion closing condition if the subject matter being opined on is not material to the transaction or does not exceed a specified amount
- Agree to an automatic or long-term extension of the termination date while the deal is being restructured, litigation remains unresolved or other developments challenge deal certainty
- Include a significant termination or reverse termination fee if a party’s refusal to close is because of a failure to obtain a tax opinion
- If the transaction involves an auction process, require the topping bidder to pay any breakup fee that the target must pay to terminate another proposed transaction and accept the topping bid
- Make alternative arrangements:
- Require tax opinions at closing, but if the party’s counsel will not issue the tax opinion, require the party to accept the opinion issued by the other party’s counsel
- Require tax opinions at closing, but if the party’s counsel will not issue the tax opinion, require the party to accept the opinion issued by a third party alternative counsel
- Provide the counterparty with the option to purchase insurance in lieu of delivering a tax opinion to insure against the risk that the opinion would otherwise cover