Annual survey of judicial developments pertaining to mergers and acquisitions

Annual survey of judicial developments pertaining to mergers and acquisitions

Annual survey prepared by the Subcommittee on Recent Judicial Developments of the Negotiated Acquisitions Committee of the American Bar Association’s Section of Business Law.


This annual survey was prepared by the Subcommittee on Recent Judicial Developments of the Negotiated Acquisitions Committee of the American Bar Association’s Section of Business Law. The Subcommittee on Recent Judicial Developments was formed at the 2002 Annual Meeting of the American Bar Association in Washington, D.C. The primary charge of the Subcommittee on Recent Judicial Developments is to summarize, on an annual basis, significant judicial decisions in the area of mergers and acquisitions (“M&A”), and to publish that summary as a service to ABA members who practice in the M&A area.

The annual survey is written from the perspective of the practicing M&A lawyer. The summarized cases are limited to those believed to be of greatest interest to a wide range of M&A practitioners, and to exceed a threshold of importance. To be included in the survey, cases must meet two criteria regarding the type of transaction involved and the substantive holding of the court. First, the decision must involve a merger, an equity sale of a controlling interest, a sale of all or substantially all assets, a sale of a subsidiary or division, or a recapitalization resulting in a change of control. Second, the decision must (i) interpret or apply the provisions of an acquisition agreement or an agreement preliminary to an acquisition agreement (e.g. a letter of intent, confidentiality agreement, or standstill agreement)



AES Corp. v. The Dow Chemical Company (“Non-Reliance” Provisions Unenforceable to Bar 10b-5 Claim)

AES Corp. v. The Dow Chemical Company (1) involved the issue of whether an acquirer’s agreement to so-called “non-reliance” provisions in acquisition documents barred the acquirer, as a matter of law, from bringing a post-closing claim based on Rule 10b-5 of the Securities Exchange Act of 1934 (the “Exchange Act”). The seller argued that it was impossible for the acquirer to meet the “reasonable reliance” element of a Rule 10b-5 claim in light of the express non-reliance provisions

The case arose from AES’s purchase of certain assets of Destec Energy, Inc. including the capital stock of Destec Engineering Inc. (“DEI”), a wholly owned subsidiary of Destec Energy The Dow Chemical Company (“Dow Chemical”) was the majority shareholder of Destec Energy “DEI’s sole asset was a contract to design and construct a power plant in the Netherlands.” (3) AES claimed that Dow Chemical sold DEI to AES at an artificially inflated price by making misrepresentations material to AES’s evaluation of DEI, including misrepresentations regarding the predicted completion date and potential profit of the power plant project. AES claimed that it lost $70 million on the power plant project instead of receiving $31 million in profits allegedly predicted.

The acquisition documents used and entered into in connection with the transaction, including a confidentiality agreement, a confidential offering memorandum, and an asset purchase agreement, contained so-called “non-reliance” provisions that expressly stated that neither Destec Energy nor Dow Chemical was making any representations or warranties to AES other than those set forth in the definitive asset purchase agreement, and that AES was not relying on any representations and warranties of Destec Energy or Dow Chemical other than those set forth in the definitive asset purchase agreement. The definitive asset purchase agreement contained over twenty single-spaced pages of representations and warranties, but did not contain any specific representation or warranty regarding the power plant project. As part of AES’s due diligence investigation, however, AES did receive information regarding DEI and the power plant project through management presentations, the review of documents in a data room, and on-site visits.

The district court, relying on the decision of the U.S. Court of Appeals for the Second Circuit in Harsco Corp. v. Segui, (4) determined that section 29(a) of the Exchange Act, which prohibits anticipatory waivers of compliance with duties imposed by the Exchange Act, did not bar the enforcement of non-reliance provisions appearing in a final acquisition agreement “negotiated between sophisticated parties in an arm’s length transaction.” (5) As a result, the district court granted summary judgment in favor of Dow Chemical, holding that the non-reliance provisions contained in the definitive asset purchase agreement between AES and Destec Energy established that reliance by AES on any representations or warranties by Destec Energy or Dow Chemical made outside the definitive asset purchase agreement was unreasonable as a matter of law. (6)

The U.S. Court of Appeals for the Third Circuit reversed the district court’s decision. (7) The court of appeals, applying federal law, stated that determining what constitutes reasonable reliance in the context of a Rule 10b-5 claim is case-by-case analysis based on all of the surrounding circumstances. (8) In making this determination, the court of appeals identified five non-exclusive factors to aid in deciding whether a party’s reliance was reasonable under all of the circumstances. These factors, originally set forth in 5traub v Vaisman & Co., (9) included: (i) whether a fiduciary duty existed between the parties

As a result, the court of appeals, citing the decision of the U.S. Court of Appeals for the First Circuit in Rogen v. Ilikon, (12) held that non-reliance provisions, although providing some evidence of the absence of reliance, are not a bar as a matter of law to satisfying the reasonable reliance element of a Rule 10b-5 claim. (13) The court of appeals stated that “non-reliance clauses are … among the circumstances to be considered [by courts] in determining the reasonableness of any reliance” in a particular case but do not provide absolute immunity. (14) The court of appeals did state, however, that a buyer that agrees to a non-reliance provision “will have to show more to justify its reliance than would a buyer” that has not agreed to a non-reliance provision, particularly in the context of a negotiated acquisition agreement between sophisticated parties. (15)

The court of appeals remanded the case to the district court for further proceedings to determine the reasonableness of AES’s reliance on Dow Chemical’s representations in light of the factors set forth in Straub. (16)

This case creates a split among the federal circuits regarding this important M&A issue. Until this split is resolved, M&A practitioners should consider non-reliance provisions in light of the jurisprudence of the federal circuits in which a 10b-5 claim arising from the transaction might be litigated. Further illustrating the unsettled nature of this area of M&A law are the Poth v. Russey (17) case, the Consolidated Edison, Inc. v. Northeast Utilities (18) case, and the Merrill Lynch & Co. v. Allegheny Energy, Inc. (19) case, which are summarized below.

Poth v. Russey (“Non-Reliance” Provisions Support Summary Judgment Dismissing 10b-5 Claim)

In Poth v. Russey, (20) the court used a facts and circumstances approach, similar to the approach used in the AES case summarized above, to determine the reasonableness of reliance in connection with a Rule 10b-5 claim. This case involved the merger of Excalibur Cable Communications, Ltd. and Viasource Communications, Inc. The plaintiff, the founder and former CEO of Excalibur, claimed that the directors of Viasource made oral representations to him during the merger negotiations that Viasource breached post-closing The defendant directors sought summary judgment with respect to plaintiff’s Rule 10b-5 claims on the basis that plaintiff’s reliance on such oral representations was unreasonable.

The court stated that the parties’ “[m]erger [a]greement contained an integration provision and an ‘arms-length negotiation’ provision, which stated that each party … ‘fully informed itself of the terms, contents, conditions and effects of [the] [m]erger [a]greement'” and that the merger agreement contained specific provisions that contradicted the purported oral representations. (21)

The court then used an eight factor test developed by the U.S. Court of Appeals for the Fourth Circuit to determine whether plaintiff’s reliance was reasonable. This test is similar to the Straub test used by the Third Circuit in the AES case. The eight factors are:

[i] the sophistication and expertise of the plaintiff in financial

and securities matters

business or personal relationships


concealment of the fraud

[vii] whether the plaintiff initiated the stock transaction or

sought to expedite the transaction

specificity of the misrepresentations. (22)

Based on this analysis, the court found that seven of the eight factors favored the defendant directors and that the other factor (i.e., factor (vii)) was neutral between plaintiff and defendants. (23) Therefore, the court held that plaintiff’s reliance on the defendant directors’ oral representations was unreasonable as a matter of law and granted summary judgment in favor of the defendant directors. (24)

Consolidated Edison, Inc. v. Northeast Utilities, (“Non-Reliance” Provisions Support Summary Judgment Dismissing Fraudulent Inducement and Negligent Misrepresentation Claims)

The court, in Consolidated Edison, Inc. v Northeast Utilities, (25) considered non-reliance language, and facts and circumstances, in rejecting an acquirer’s claims based on state law fraudulent inducement and negligent misrepresentation theories. This case arose from a failed $3.6 billion dollar acquisition by Consolidated Edison, Inc. (“Con Ed”) of Northeast Utilities (“Northeast”). In the litigation, Con Ed sought, among other things, to terminate the merger agreement based on alleged misrepresentations made by Northeast during the due diligence process. Northeast counterclaimed against Con Ed for breach of the merger agreement.

After a due diligence period that extended over five months and involved numerous Con Ed and Northeast officers and employees, in-house and outside counsel, due diligence experts and investment bankers, Con Ed and Northeast entered into a merger agreement on October 13, 1999. The merger price to be paid by Con Ed was half cash and half Con Ed stock. The anticipated merger price represented a forty percent premium over the trading price of Northeast’s stock.

The dispute between the parties revolved around an unregulated subsidiary of Northeast called Select Energy. Select Energy was an energy marketing company that sold wholesale electricity to large energy users. Select Energy signed a four-year agreement to supply electricity (the “Supply Agreement”). Although the Supply Agreement was entered into after the merger agreement was signed, Con Ed was aware, before signing the merger agreement, that Northeast intended to enter into the Supply Agreement.

The Supply Agreement obligated Select Energy to supply electricity at a predetermined fixed price during the four-year period. In order to make a profit, Select Energy had to secure supply below the fixed price outlined in the Supply Agreement. Select Energy only secured supply for the first two years of the Supply Agreement, and therefore risked significant financial losses for years three and four if the electricity market price increased beyond the fixed price.

Con Ed alleged that Northeast had orally represented, during due diligence, that Select Energy had purchased enough energy to meet its four-year obligations under the Supply Agreement. The merger agreement did not specifically contain any representations or warranties relating to the Supply Agreement or whether the four-year supply obligation was sufficiently matched.

The confidentiality agreement signed by the parties at the outset of the negotiations contained an express disclaimer of reliance on any representations and warranties made during the due diligence process. Further, the merger agreement contained an integration clause that barred reliance on any representation not explicitly set forth in the merger agreement. Given these provisions and with the army of financial and legal advisors that were at Con Ed’s disposal, the court determined that, if the Supply Agreement was indeed material, as Con Ed had alleged, it should have been referred to in the merger agreement. (26) The court further determined that under these circumstances Con Ed could not “establish that it reasonably relied on the alleged oral representations” about the Supply Agreement. (27) Accordingly, the court granted Northeast’s motion for summary judgment on Con Ed’s fraudulent inducement and negligent misrepresentation claims. (28)

The court permitted the litigation to continue between the parties on other grounds, including Con Ed’s claim that the execution of the Supply Agreement constituted a change in the ordinary course of conduct of Select Energy’s business and was also a material adverse change which allowed Con Ed to terminate the merger agreement. (29)

Merrill Lynch & Co. v. Allegheny Energy, Inc. (“Non-Reliance” Provisions Unenforceable to Bar Fraudulent Inducement Claim)

In Merrill Lynch & Co. v. Allegheny Energy, Inc., (30) the court refused to dismiss state-law fraudulent inducement claims brought by the buyer of an energy commodities trading business, despite the existence of “non-reliance” provisions in both the confidentiality agreement and the asset purchase agreement executed by the buyer in that transaction. (31) This case arose out of the purchase, by Allegheny Energy, Inc. (“Allegheny”), from Merrill Lynch & Co. and one of its affiliates (“Merrill Lynch”), of the commodities trading business owned by Merrill Lynch and known as Global Energy Markets (“GEM”). In late 2000, Allegheny, “which provides retail electric and natural gas services to residents of several mid-Atlantic states, sought to acquire an energy-commodities trading business in order to expand” the business of its energy trading subsidiary. (32) Allegheny approached Merrill Lynch, who had acted as Allegheny’s long-time financial advisor, with a view toward having Merrill Lynch locate a suitable target company. Merrill Lynch instead introduced Allegheny to GEM and (after withdrawing as Allegheny’s advisor) made several presentations to Allegheny about GEM as a potential target for Allegheny.

In September 2000, the parties executed a Confidentiality Agreement governing the parties’ use and exchange of information in connection with the transaction. The confidentiality agreement survived the closing of the transaction, and contained an express disclaimer of any liability with respect to any information supplied during the due diligence process, and a statement that only the representations and warranties to be set forth in the definitive agreement would have any legal effect.

In January 2001, the parties entered into an Asset Contribution and Purchase Agreement (the “APA”), which contained the following non-reliance provision:

Except for the representations and warranties contained in this

Article III, neither the Sellers nor any other Person make any

express or implied representation or warranty on behalf of or

with respect to the Sellers, the Business or the Purchased Assets,

and the Sellers hereby disclaim any representation or warranty

not contained in this Article III. (33)

The APA also contained what the court referred to as “a standard merger clause” under which the parties agreed that the APA constituted their entire agreement and superceded all prior written and oral agreements other than the confidentiality agreement. (34)

The transaction was closed in the spring of 2001. Allegheny paid to Merrill Lynch $490 million in cash and a two percent equity interest in its trading subsidiary. The APA also provided that Allegheny was to contribute certain generation assets to its trading subsidiary by September 16, 2002, failing which Merrill Lynch had the right to “put” its equity interest to Allegheny for $115 million.

After the closing, “Allegheny soon realized that GEM’s financial performance was based in part on sham [transactions] with Enron” and possibly others, and that GEM’s CEO, Daniel Gordon, had employed “highly questionable, if not criminal, business practices”, including so-called “wash” and “round trip” energy trades, and an allegedly fraudulent $43 million trade with an Anguilla-based corporation that Allegheny believed Gordon owned or controlled. (35) Following these revelations, Allegheny refused to contribute the generation assets to its trading subsidiary, as required by the APA, and Merrill Lynch brought suit. Allegheny brought counterclaims against Merrill Lynch for rescission, fraudulent inducement, breach of fiduciary duty, and negligent misrepresentation. This decision resolved Merrill Lynch’s motions to dismiss those counterclaims.

The court cited both the Consolidated Edison, Inc. case (36) and Harsco Corp. v. Segui (37) as indicating “the general hostility of courts to claims by sophisticated business entities for fraudulent inducement.” (38) Nevertheless, Judge Baer, who authored the opinion, went on to state that “under the standards applicable at this stage of the litigation, I am unwilling to conclude as a matter of law that Allegheny’s reliance on these alleged misrepresentations was unreasonable.” (39) The court distinguished Harsco and Consolidated Edison on the basis of the following representation by Merrill Lynch in the APA: “[t]he information provided by Sellers to Purchasers, in the aggregate, includes all information known to Sellers which, in their reasonable judgment exercised in good faith, is appropriate for Purchasers to evaluate the trading positions and trading operations of the Business.” (40)

According to the court, whereas the agreements in Harsco and Consolidated Edison “placed the burden on the buyer to perform its due diligence and to ensure that the representations in the final agreement covered known or readily knowable risks,” the APA at issue in this case “places at least some of that burden on Merrill Lynch.” (41)

The court also found “significant” that Merrill Lynch had a fiduciary relationship with Allegheny, which existed until shortly before the APA was executed. (42) Finally, Allegheny alleged that the information was peculiarly within Merrill Lynch’s knowledge, which, under the reasoning of Banque Arabe et Internationale D’Investissement v Maryland National Bank, (43) renders an express waiver or disclaimer ineffective. The Allegheny decision is also interesting in its analysis of Allegheny’s breach of contract claims. Specifically, Allegheny alleged that, by failing to disclose the sham trades with Enron and perhaps others, and the problems with Mr. Gordon, Merrill Lynch breached three representations and warranties in the APA.

First, Allegheny alleged that Merrill Lynch breached its representation that:

[e]xcept as set forth in Section 3.05 of the Sellers’ Disclosure

Schedule, the Sellers are conducting the Business in compliance in

all material respects with all applicable Laws, and all material

governmental approvals, permits and licenses … required for the

Sellers to conduct the Business as currently conducted have been

obtained. (44)

Merrill Lynch argued that the words “are conducting” as used in this representation meant that the “representation should only encompass activities as of the date of the [closing,]” and because the Enron trades were in the past, the representation was not breached. (45) The court seemed sympathetic to this defense, but refused to dismiss this allegation because Allegheny also pleaded that Merrill Lynch made other unspecified sham trades that may have been in effect on the closing date. (46)

Allegheny also alleged that the sham trades improperly inflated GEM’s revenues, resulting in a breach of the representation that GEM’s financial records were “in all material respects true, complete and correct.” (47) Merrill Lynch defended this claim on the basis that the fees that it earned on the trades with Enron were accurately and properly reported and reflected on the financial statements. According to the court, however, even if it were true that the “books were ‘in all material respects true, complete and correct,’ Allegheny’s allegations also touch[ed] on the [introductory] part of [the] representation … that the ‘Business Selected Data has been prepared in good faith.'” (48)

Finally, Allegheny alleged that Merrill Lynch breached the representation quoted above, that the information provided by Merrill Lynch to Allegheny, in the aggregate, included all information known to Merrill Lynch, which, in Merrill Lynch’s reasonable judgment exercised in good faith, was appropriate for Allegheny to evaluate “the trading positions and trading operations” of GEM. (49) Merrill Lynch argued that the representation was not breached because “the Enron trades were not part of GEM’s ‘trading positions and trading operations’ when the [APA] became effective in early 2001.” (50) The court disagreed with Merrill Lynch’s interpretation of this representation, stating that “it is difficult to see how the information about the sham Enron trades, even if they were cancelled before the Purchase Agreement, would not be appropriate in order for Allegheny to evaluate GEM’s trading positions and trading operations.” (51)

Another contract interpretation issue in this case was Merrill Lynch’s contention that Allegheny should not be allowed to pursue any claims based on the $43 million trade with Falcon Energy, the Anguilla-based corporation that Allegheny believed Mr. Gordon owned or controlled, because Allegheny had failed to specify the Falcon Energy trade in its claim notice, which was given on the last day of the eighteen month survival period provided for representations and warranties in the APA. The court disagreed with Merrill Lynch on the basis that the notice provision did not include any language requiring that the claim notice describe the basis for the claim with specificity. (52) The APA provided only that “written notice of a claim [be] given prior to the expiration of the applicable representations and warranties.” (53) The court distinguished the survival clauses in the cases relied on by Merrill Lynch in its defense on the basis that those survival clauses included requirements that the claim be made “with specificity” or that the party “specify[] the nature and amount” of the claim. (54)

Like AES, Poth, and Con Ed, Allegheny is a good reminder to M&A practitioners of the importance of non-reliance provisions, which are sometimes overlooked as “boilerplate.” These cases also illustrate the importance to the acquirer of specifically identifying and allocating the risks of material business issues in the transaction documents, as opposed to relying on oral representations made during due diligence, or on the broadly worded, generalized representations, warranties, and covenants that are typically contained in M&A agreements.

AIH Acquisition Corp. v. Alaska Industrial Hardware, Inc. (Enforcement of Unsigned Stock Purchase Agreement)

In AIH Acquisition Corp. v. Alaska Industrial Hardware, Inc., (55) the U.S. District Court for the Southern District of New York granted an acquirer’s claim for specific performance of an unexecuted stock purchase agreement. (56)

AIH Acquisition Corp. (“Acquisition”) entered into a letter of commitment to purchase the stock of Alaska Industrial Hardware (“Alaska Industrial”). Acquisition had completed its due diligence, participated in extensive negotiations, and thought it had reached agreement on a final stock purchase agreement that only awaited execution. At that point, Alaska Industrial’s majority shareholder refused to sign the agreement.

Plaintiffs sought specific performance of the contract or, in the alternative, contract damages. Plaintiffs also brought claims for fraud and negligent misrepresentation against Alaska Industrial, its stockholders, and its lawyers. Defendants sought to dismiss the claims, inter alia, for failure to state a claim.

The court found that the parties had a “complete written agreement containing all material terms in final form with signatures coming the next day as a mere formality.” (57) The court’s conclusion was based in part on an e-mail from Acquisition’s counsel to Alaska Industrial’s counsel stating that the “final” stock purchase agreement was attached and indicating that “[e]veryone, including the lawyers, has stated it is final without qualification.” (58) The court also found that, because plaintiffs had alleged that Alaska Industrial was a closely held company without readily ascertainable value, they had properly alleged that there was no adequate remedy at law and had properly stated a claim for specific performance. (59)

The court dismissed plaintiff’s fraud and misrepresentation claims against Alaska Industrial and its lawyers, rejecting the theories “that the lawyers[] fraudulently offered repeated assurances that the deal would close, and that their failure to disclose information as to [the majority stockholder’s] mental condition constituted fraudulent misrepresentation.” (60)

This is a shocking case for business lawyers, who routinely operate under the legal premise that where the parties intend their agreement will be reduced to writing, they are not bound until the written agreement is executed. The decision in this case contains limited detail regarding the underlying facts, but it may be that the court’s decision was influenced by allegations that the majority shareholder exhibited particularly egregious behavior. Nevertheless, this case is a reminder that there are exceptions even to the rule that the deal is not done until the documents are signed.

Horizon Holdings, L.L.C. v. Genmar Holdings, Inc. (Damages Awarded for Lost Earn-out)

In Horizon Holdings, L.L.C. v. Genmar Holdings, Inc., (61) the court denied several post-trial motions through which the defendants sought to overturn a jury verdict awarding $2.5 million to the plaintiffs for a lost earn-out. (62) The case involved the acquisition by Genmar Manufacturing of Kansas, LLC (“Genmar Kansas”) of the aluminum boat manufacturing business of Horizon Holdings, LLC (“Horizon”). The purchase agreement explicitly provided that Horizon and Geoffrey Pepper (“Pepper”) would have an opportunity to realize up to $5.2 million in earn-out consideration, defined in the agreement as part of the purchase price.

It appears from the court’s opinion that a number of issues relating to the earnout discussed by the parties prior to the execution of the agreement were not covered in the agreement. These included (i) the authority Pepper would have as President of Genmar Kansas

The operations of Genmar Kansas following the acquisition did not produce earnings supporting the payment of any earn-out consideration under the formula set forth in the purchase agreement. Horizon and Pepper sued for the lost earn-out, claiming that “defendants breached both the express terms of the purchase agreement … and the duty of good faith and fair dealing implied in the purchase agreement.” (63) They also claimed that defendants made a variety of fraudulent misrepresentations to induce them to enter into the purchase agreement.

Pepper testified that, “in his mind,” the thirteen percent gross profit margin necessary to achieve the earn-out was reasonable and obtainable, but that “he needed a certain level of autonomy with respect to the management of Genmar Kansas to ensure that [it] would realize the profits and revenues necessary” to support the earn-out. (64) Specifically, he testified that he sought (and received) assurances that the buyer would allow him “to do what is necessary in managing the company to obtain that earn-out.” (65) He also testified that he was assured that “he would be in control of Genmar Kansas’ operations.” (66)

The plaintiffs’ claim with respect to the implied covenant of good faith and fair dealing was that it was a breach of that covenant for the defendants to undermine Pepper’s authority as president of Genmar Kansas and to take other actions that had the effect of depriving plaintiffs of the opportunity to achieve the earn-out. The defendants claimed that plaintiffs were purporting to rewrite the contract and supply omitted provisions. The agreement specified that it would be governed by Delaware law. The jury was instructed that under Delaware law they should consider “whether it is clear from what was expressly agreed upon by the parties that the parties would have agreed to prohibit the conduct complained of as a breach of the agreement had they thought to negotiate with respect to that matter.” (67) The jury was further instructed that a “violation of the implied covenant of good faith and fair dealing implicitly indicates bad faith conduct.” (68)

The jury returned a verdict for the plaintiffs on their breach of contract claim, and awarded $2.5 million in damages for the lost earn-out. In denying defendants’ motion for judgment as a matter of law, the court found more than sufficient evidence to support conclusions that:

the parties would have agreed, had they thought about it, that

defendants would not be permitted to undermine Mr. Pepper’s

authority as president of Genmar Kansas

brand name entirely

Crestliner brands at the Genmar Kansas facility to the detriment

of the Horizon brand

“standard cost” for the manufacture of Ranger and Crestliner

boats thereby impairing realization of the earn-out. (69)

With respect to the issue of bad faith, the court was of the view that the jury could have reasonably concluded that these actions were designed to force Pepper to quit (extinguishing any earn-out claim) or to prevent Pepper from achieving the profit margins necessary to realize the earn-out. (70)

The defendants argued to the jury and to the court that the plaintiffs’ characterization of the evidence made no sense because defendants made no money on the Horizon acquisition. With respect to this argument, the court thought the evidence sufficient to support the conclusion that:

defendants believed (but were ultimately incorrect) that they could

still turn a profit through the production of Ranger and Crestliner

boats at Genmar Kansas while simultaneously preventing Mr. Pepper

from realizing any earnout by stifling the production of Horizon

boats and reimbursing Genmar Kansas only at standard cost for the

production of other boats. (71)

Thus, the jury could reasonably find bad faith, in the court’s view.

The defendants also sought judgment as a matter of law on the plaintiffs’ damages claim, asserting that there was no evidence permitting the jury to ascertain what position plaintiffs would have been in had the purchase agreement been properly performed, and that recovery was precluded “because Genmar Kansas was a new business with no profit history and [there was] no evidence … from which the jury could conclude that Genmar Kansas was reasonably certain to realize the gross profit margins necessary to achieve [the] earn-out.” (72) The court stated that any doubts on the proof of damages should be resolved against the party in breach, and cited evidence that Pepper thought thirteen percent gross profit margins could be achieved, and evidence from which the court believed the jury could conclude that Horizon Marine was about to “break into the black” just before the acquisition, as evidence from which a jury could reasonably conclude that, if defendants had allowed Pepper to direct daily operations, the requisite profit margins would have been achieved. (73)

The court denied defendants’ new trial motions for the reasons that it gave for denying the motion for judgment as a matter of law. (74) One ground for the new trial motions was that the court erred in admitting parol evidence regarding the parties’ negotiations. The defendants argued that parol evidence is inadmissible to prove bad faith in a breach of contract claim. The court pointed out that the evidence had been admitted with respect to plaintiffs’ claim that the defendants had fraudulently induced them to enter into the agreement, and that the defendants at that point failed to request a limiting instruction with respect to consideration of the evidence with respect to the good faith and fair dealing claim. (75) The court therefore reviewed the admission of the evidence under the plain error standard, concluding that there was no plain error, and further stating that the issue was largely moot because the court would have permitted the jury to consider the evidence in connection with the good faith and fair dealing claim in any event. (76) The court also asserted that, because the purchase agreement was silent as to “the majority of the issues discussed by the parties prior to execution of the agreement,” evidence as to those discussions is entirely appropriate to “provide context” for the good faith and fair dealing claim. (77)

Finally, the court awarded the plaintiffs over $800,000 in attorneys’ fees and expenses under a provision of the purchase agreement providing that “the prevailing party shall be entitled to recover from the defaulting party all costs and expenses, including reasonable attorneys’ fees, incurred in connection with enforcing the terms of the purchase agreement.” (78)

The Horizon Holdings case illustrates some of the tensions that are created when an earn-out is in place. The buyer will normally assume that, at least as to significant business decisions, it is entitled to operate the business it has purchased. But decisions in the buyer’s interest (such as using the acquired facility to produce several lines of boats and thus achieve some synergistic benefits) may be directly contrary to the seller’s interest in achieving the earn-out. Earn-out agreements are frequently quite detailed in order to deal explicitly with these conflicting interests. Although either party may decide for good reasons not to explicitly address in the document one or more earn-out related issues where there are conflicting interests, this case illustrates the risks in that approach, particularly if the issues were discussed during negotiation.

In the Matter of Westmoreland Coal Company (Relationship Between Indemnification and Purchase Price Adjustment Provisions)

The court in In the Matter of Westmoreland Coal Company (79) was confronted with a dispute involving whether the seller’s valuation of certain assets complied with generally accepted accounting principles (“GAAP”). The specific issue before the court was whether the dispute should be resolved by means of litigation under the indemnification provisions of the purchase agreement, or by means of the alternative dispute resolution procedures contained in the purchase price adjustment provisions of the agreement.

The Westmoreland Coal Company (“Westmoreland”) acquired several subsidiaries (the “Subsidiaries”) of Entech, Inc., (“Entech”) in a stock purchase transaction. In the stock purchase agreement, Entech represented and warranted that the Subsidiaries’ unaudited financial statements for various years “were prepared in accordance with GAAP.” (80) The stock purchase agreement also contained a post-closing purchase price adjustment mechanism under which the purchase price would be adjusted based upon a calculation of the asset values of the Subsidiaries as of the closing date.

Under the purchase price adjustment procedure, Entech was required to present Westmoreland with its calculation, and Westmoreland had thirty days to register any objections. The procedure included a mandatory fifteen-day mediation period, following which (if the mediation was unsuccessful) the dispute would be referred to a nationally recognized independent accountant. The independent accountant was required to decide the dispute and determine the purchase price adjustment within thirty days of the referral, and the determination by the independent accountant would be binding on the parties.

Entech calculated the purchase price adjustment and delivered to Westmoreland a certificate detailing its calculations. Westmoreland disagreed with the calculations on the basis that certain asset valuations did not comply with GAAP. Westmoreland further argued that the dispute was required to be submitted to the independent accountant. Entech, however, took the position that because the asset values on the certificate were consistent with the financial statements referred to in the stock purchase agreement, and because the stock purchase agreement contained a representation and warranty by Entech that those financial statements were prepared in accordance with GAAP, the exclusive remedy available to Westmoreland was to claim a breach of that representation and warranty. Pursuant to the indemnification provisions of the purchase agreement, such a claim would be resolved through litigation, and would be subject to the $1.75 million “basket” on indemnification claims (that is, even if Westmoreland was successful, Entech would not be responsible for the first $1.75 million awarded in the litigation).

The court held that Westmoreland’s valuation objections should be resolved under the indemnification provisions and not under the purchase price adjustment provisions of the stock purchase agreement. (81) The court focused on several factors in reaching its decision. The first factor was that the purchase price adjustment provisions required Entech to prepare the certificate on a basis consistent with the financial statements referred to in the stock purchase agreement. (82) According to the court, this provided consistency between the values used as of the date of the purchase agreement and as of the closing date. (83)

The second factor was that Entech specifically represented and warranted that the financial statements were prepared in accordance with GAAP. (84) The indemnification provisions were extensively negotiated, with specific attention to the amount of post-closing liability for breaches of representations and warranties, limited periods of time for claims to be brought, and liability thresholds. The court reasoned that Westmoreland’s position would circumvent these specific points negotiated and agreed to by the parties. (85)

The final factor analyzed by the court was the concern that Westmoreland’s position would undermine the role of due diligence in complex transactions. (86) Westmoreland was presumably aware of Entech’s accounting practices during the course of due diligence. The court reasoned that if Westmoreland was concerned about those accounting practices, it should have raised them during the due diligence process and specifically addressed them in the purchase agreement. (87) Because Westmoreland negotiated for the representation and warranty from Entech that the financial statements were prepared in accordance with GAAP, the most appropriate avenue resolving the dispute over the application of GAAP to the asset values was the indemnification remedies under the purchase agreement. (88)

Chemetall GMBH v. ZR Energy, Inc. (Asset Acquirer Allowed to Enforce a Contract It Did Not Specifically Assume)

In Chemetall GMBH v. ZR Energy, Inc., (89) the U.S. Court of Appeals for the Seventh Circuit upheld a jury verdict finding that defendant, Joseph T. Fraval (“Fraval”), breached the confidentiality provision under his Employee Trade Secret Agreement and “willfully and unlawfully misappropriated trade secrets” that plaintiff, Chemetall GMBH (“Chemetall”), acquired from Fraval’s former employer, Morton International and its predecessors (“Morton”). (90) Fraval had worked for Morton in the business of producing 7irconium powder for twenty years. During that time, Fraval entered into an Employee Trade Secret Agreement (91) with Morton that was to extend beyond his employment and, by its terms, was intended to “inure to the benefit of [Morton’s] successors and assigns.” (92) Three years after Morton sold its zirconium powder business to Chemetall, Fraval left Morton and formed ZR Energy to produce and market zirconium powder. Chemetall sued Fraval for breach of his agreement with Morton not to use or disclose its confidential information.

Fraval’s appeal attacked the district court’s ruling that Chemetall acquired the right to enforce Fraval’s confidentiality obligation. The court was unconvinced by Fraval’s arguments that his confidentiality obligation was not transferred in the sale. The court found that a provision in the Asset Purchase Agreement stating that no employee of Morton would become an employee of Chemetall, and no liability or obligation with respect to any employees of Morton, including any employment agreement, would be assumed by Chemetall, did not negate an assignment to Chemetall of Fraval’s confidentiality obligation. (93) The court also rejected Fraval’s argument that the confidentiality obligation did not transfer because it was not contained on the list of included assets. (94)

The court noted that, although the Asset Purchase Agreement did not mention Fraval’s Employee Trade Secret Agreement on the list of included assets, the Asset Purchase Agreement did specifically refer to confidential information relating to the acquired assets, along with the obligations of Morton and its employees with regard to that information. (95) Although the court found that the terms of the Asset Purchase Agreement did “not conclusively establish the parties’ intent with respect to Fraval’s … confidentiality agreement,” the court noted that the terms were consistent with an intent to preserve the confidentiality obligations for the benefit of Chemetall, and, therefore, upheld the district court’s denial of Fraval’s pretrial motion and allowed evidence on the question of the parties’ intent. (96) In addition, the court rejected Fraval’s argument that a jury instruction improperly failed to take into account that Fraval’s agreement with Morton was a personal services contract, for which the duty to perform cannot be delegated, noting that “there was no assignment of Fraval’s duty of performance but only of Morton’s right to enforce that duty.” (97) The court held that “Fraval’s performance was in no way affected by the identity of the party entitled to enforce that performance.” (98)


Lawton v. Nyman (Disclosure Obligations Pertaining to Acquisition of Stock from Minority Shareholders)

In Lawton v. Nyman, (99) the corporation redeemed minority shares of Class A (non-voting) stock in a series of transactions from November 1995 through May 1996 at prices ranging from $145.36 to $200.00 per share. During the same period, the directors issued themselves options at exercise prices of $200.00 to $220.00 per share and purchased Class A and Class B (voting) treasury shares for $200.00 per share.

In October 1996, approximately five months after the purchases from minority stockholders were completed, the company opened discussions with a prospective purchaser that led to the signing of a letter of intent in June 1997 and the closing in September 1997 of a transaction in which the purchaser paid $1,667.38 per share for the Class A stock and $2,167.59 per share for the Class B stock.

Minority stockholders whose shares were redeemed during the prior two years sued the directors (who were also the officers and controlling stockholders) for breach of fiduciary duty, violation of federal securities laws, and common law fraud, asserting that they were paid less than the stock’s true value, that the defendants “knew that the company might be sold,” and that material facts were misrepresented and not disclosed. (100) A parallel suit alleged that the option grants and purchases of treasury stock diluted the ownership of the remaining minority stockholders.

The district court dismissed the securities law claims, but found a breach of fiduciary duty by the defendants. The court of appeals’ opinion dealt primarily with its reasons for affirming the finding of a breach of fiduciary duty under Rhode Island law and with the appropriate measure of damages. The court found no direct Rhode Island precedent, but concluded that Rhode Island would be likely to adopt the “special facts” rule, under which officers or directors of a closely held corporation purchasing a minority stockholder’s shares must disclose all material facts affecting the value of the stock known to them by virtue of their positions, but not known to the selling stockholder. (101)

On appeal, the issue of liability turned on the proper standard for determining materiality. The district court concluded that “negotiations for a sale need not be underway for there to be a duty to disclose[, but that] the duty also encompasses transactions that the directors anticipate are reasonably likely to occur or that are something more than remote possibilities.” (102) Before addressing the issue of materiality, the court of appeals recognized that the duty to disclose a possible sale or merger to selling minority stockholders is greater in the closely held corporation context than in the situation of a publicly held corporation because, among other reasons, premature disclosure by a publicly held target could lead to inflation of the target’s stock price, and thus possibly prevent the transaction from occurring. (103)

On the issue of materiality, the court of appeals acknowledged that “[i]f the finding of breach of fiduciary duty turned purely on the definiteness of the plan to sell,” the issue would be difficult, but emphasized that the case turned instead “on an interrelated series of non-disclosures and misrepresentations.” (104) The court noted, among other things, that “the redemption of the plaintiffs’ stock represented a marked departure from the company’s previous lack of interest in purchasing stock

The risk of Lawton-type liability can be reduced by careful attention, with the participation of counsel, to disclosure issues whenever minority shares are being acquired, particularly if the situation involves isolated purchases from minority stockholders who initiate the transactions, rather than an effort by management to accumulate minority shares. But even if no sale is on the horizon at the time of purchase, management should take into account that a future sale of the company at a premium price will increase the likelihood of a lawsuit by minority stockholders, and that the adequacy of disclosure, as always, will be judged in hindsight. The importance of adequate disclosure is further heightened by the fact that a court may very well ignore any waivers of disclosure duties, as is discussed below in the summary of the Neubauer decision.

An important question for practitioners is how to identify the line between closely held and publicly traded corporations for purposes of determining whether Lawton duties apply. In light of the rationale for the non-applicability of the “special facts” rule to publicly held corporations, as articulated in Lawton and in Jordan, it may be risky to construe “closely held” narrowly. Indeed, a selling minority stockholder plaintiff may argue that a corporation that has recently gone private and no longer files reports under the Securities Exchange Act of 1934, and still has one or two hundred stockholders but no active market for its stock, is no longer “publicly held” and should be regarded as “closely held” for these purposes, because disclosure to a minority stockholder regarding a prospective sale of the company would not be likely to endanger the potential transaction.

Although it affirmed the district court’s liability finding, the court of appeals remanded the case for further proceedings on the appropriate measure of damages. (107) Rather than measure damages by the usual rule (the difference between the value of the stock when sold and the price received by the seller), the district court awarded the plaintiffs the difference between the September 1997 sale price and the amount paid by the corporation upon redemption of the shares. The district court based this departure from the general rule on two rationales: (i) that the plaintiffs, if informed about the possibility of sale, would have retained their shares until September 1997, and (ii) that the September 1997 price was the best indication of the value of the shares sixteen months earlier. The court of appeals could find no evidence in the record to support either rationale. (108)

The district court had not independently considered the possibility of using an unjust enrichment theory of damages, because it had, mistakenly in the view of the court of appeals, regarded the defendants’ profit as equivalent to the plaintiffs’ loss (the difference between the price paid by the corporation to redeem the shares and the September 1997 sale price). (109) The court of appeals directed the district court, on remand, to consider whether equitable relief would be appropriate, and if so, whether the defendants’ profits from the September 1997 sale might be regarded as unjust enrichment. (110)

With respect to the possibility of applying an unjust enrichment remedy, the court of appeals set some general parameters to guide the district court. First, the court considered cases holding that a misled seller who fails to repurchase shares once he has learned previously undisclosed facts cannot show that the nondisclosure was a proximate cause of his failure to obtain the subsequent appreciation in value of the stock. (111) The court distinguished those cases on the basis that in the closely held corporation context the seller has no opportunity to “cover” by repurchasing shares of the corporation. Second, the court pointed out that extraordinary gains attributable to extra efforts by the defendants cannot be regarded as part of the defendants’ “windfall profits.” (112) Third, the court cited cases for the proposition that unjust enrichment is usually applied when the subsequent resale follows fairly soon after the original purchase. (113) The court also referred to the risks that the defendants took in their subsequent management of the corporation. The court mentioned the possibility that “[o]ther models of equitable relief may be better suited for the facts of [the] case, if equitable relief is warranted at all.” (114) If the “plaintiffs would have sold their shares even had they received the withheld information … any profit [the defendants] earned above the premium they would have paid the [plaintiffs] absent the fraud is not unjust enrichment.” (115) The court therefore suggested that [a]nother approach may be to rely on the premium that the plaintiffs would have extracted were the information disclosed, awarding plaintiffs “more than their loss … while not requiring the disgorgement of all of defendants’ eventual profit, some of which may have been justly earned.” (116)

Neubauer v. Goldfarb (Waiver of Disclosure Duty Invalid as a Matter of Law)

In Neubauer v Goldfarb, (117) the court held under California law that “waiver of corporate directors’ and majority shareholders’ fiduciary duties to minority shareholders in [closely held] corporations is against public policy and a contract provision in a buy-sell agreement purporting to effect such a waiver is void.” (118) The court also held under Delaware law that a majority shareholder’s “duty of ‘complete candor’ includes a duty to disclose to a minority shareholder information” that becomes known after the minority shareholder has agreed to sell the shares but before the closing takes place, where the information affects the value of the minority shares and the agreement is being amended. (119)

In 1989, Walther Neubauer and a family trust purchased 40% of the shares of HCC Industries, Inc. (“HCC”) for approximately $1 million. The remaining 60% of HCC stock was owned by Andrew Goldfarb, President and CEO, his brother Stephen, and Christopher Bateman, the CFO. In 1994, Neubauer and Andrew Goldfarb agreed that “Goldfarb would begin to pursue the sale of HCC.” (120) In 1995, the Goldfarbs entered into negotiations with two potential acquirers, discussing potential purchase prices of $40 million for 100% of HCC in one instance, and $25 million for 50% in another instance. After these negotiations stalled, the Goldfarbs began discussions with a third potential acquirer, and at that time informed Neubauer that “he needed to sign an agreement to sell his shares for a specific amount because [the acquirer] was unwilling to put substantial work into due diligence … unless it was assured Neubauer would follow through on the deal.” (121) The purchase price then being discussed with the suitor was $74 million, which would have resulted in a gross pro rata share to Neubauer of $22 million. This led to Neubauer’s execution, in October 1995, of an agreement giving HCC a two-year option to purchase his shares for $18 million. A few months later, the suitor reduced its offer to $64 million, and Goldfarb then told Neubauer that this new offer would require him to accept $14 million for his shares. After some weeks of negotiations, the option agreement was amended to lower the option price for Neubauer’s shares to $15 million. During this period of negotiations, the proposed sale died.

After this third failed attempt at a sale, Stephen Goldfarb began negotiations with Neubauer over new financial terms on which HCC would exercise its option to purchase Neubauer shares. At the same time, Andrew Goldfarb was conducting meetings with two investment banking firms in a continuing effort to sell the company. Neither the meetings with the investment bankers, nor the range of potential sale prices being discussed by the investment bankers (from $85 million to $160 million, depending on the assumptions used) was disclosed to Neubauer. The negotiations led to the company’s acquisition of Neubauer’s stock in mid-1996 for $13.5 million. The deal also included a “tail,” which provided additional payments to Neubauer if more than 40% of HCC shares were sold before November 1, 1997 for more than $15 million. Three months later, a venture capital firm purchased 65% of HCC for $98.5 million. This triggered the “tail” payment under the amended option agreement, and Neubauer received an additional $1 million, raising the total purchase price to $14.5 million for his shares, or $70 per share. The Goldfarbs and Bateman received $71.8 million for their shares, or approximately $347 per share.

The agreements executed by Neubauer, who was separately represented by counsel, contained a variety of provisions designed to prevent Neubauer from suing if the majority shareholders subsequently sold their shares for more than Neubauer received. The provisions quoted by the court in its opinion are as follows:

Seller acknowledges that neither HCC nor its officers, directors

or controlling shareholders have any fiduciary duty to seller or HCC

in connection with the execution of this agreement or a sale

including, but not limited to, the fairness of the overall

consideration or the allocation thereof.

… [s]eller … has requested and received such information in

connection with the execution of this agreement as he believes to be

necessary in order to make an informed decision to enter into this

agreement and to bind himself as set forth herein….

… [t]he provisions hereof have been thoroughly reviewed by all

parties and have been the subject of negotiations.

… Seller is desirous of having HCC sold and selling his stock,

even if such sale results in his receiving a smaller amount per

share than the other stockholders, in part because of his belief

as to the contribution to the success of HCC made by the other


… Seller understands and acknowledges that certain of the

other stockholders of HCC will receive, in a sale, compensation and

payments both for their shares and otherwise that will have the

effect of them receiving a proportionate amount of the aggregate

consideration in the sale that is greater per share than seller

will receive hereunder. Seller agrees, subject to the other

conditions of this agreement being met, not to assert any claim,

or to institute any legal, equitable, administrative or other

proceedings against HCC or any of its affiliates or stockholders

as a result of such difference.

… Seller acknowledges and agrees that the final form of a sale

may be substantially different from what has been disclosed to him

as the present form of sale currently under negotiation, due to

factors such as, but not limited to, negotiations, due diligence,

tax restructuring, changes in the post-sale ownership of HCC by the

other stockholders, and other factors, and that it could involve a

different buyer. Such final structure may have the effect of being

more favorable to individual stockholders of HCC than to seller.

… [s]o long as seller receives the cash amount contemplated

by this agreement, seller will assert no claim against HCC or any

of its affiliates or stockholders in connection herewith. (122)

Neubauer sued the directors and the majority shareholders for breach of fiduciary duty, fraud, negligence, and false statements in the purchase of securities. The trial court granted summary judgment in favor of the defendants. (123) Neubauer appealed. On appeal, the court decided two general issues: first, whether the release and waiver provisions of the contract were enforceable

The court noted that under California law, all contracts that have for their object “to exempt anyone from the responsibility for his own fraud or willful injury to the person or property of another, or violation of law,” are against public policy and void. (125) The court also stated that “[t]his public policy applies with added force when the exculpatory provision purports to immunize persons charged with a fiduciary duty from the consequences of betraying their trusts.” (126) Therefore, the court struck down the waiver provision set forth in the first quoted paragraph above. The court interpreted the remainder of the provisions quoted above as irrelevant to the issue of whether the defendants breached a disclosure duty to Neubauer in negotiating the purchase of his HCC shares. (127) According to the court, those provisions simply meant that Neubauer would “not sue the Goldfarbs merely because they ultimately obtain more for their HCC shares than Neubauer received for his,” and those provisions did not mean, as the defendants argued, that Neubauer was releasing the defendant’s from liability for breach of fiduciary duty, fraud, or negligent misrepresentation. (128)

The defendants also argued that the facts presented no triable issue of fact regarding any misrepresentations or failure to meet any disclosure duty, because none of the facts allegedly misrepresented or withheld were material. The only alleged misrepresentation before the October 1995 option agreement was signed was the alleged misrepresentation that the $25 million price discussed in the prior failed negotiation was for the whole company, when in fact it was for fifty percent. The only alleged failure to disclose before the October 1995 option agreement was signed was the failure to provide Neubauer with 1996 profit projections. The court stated that such a misrepresentation and such a failure to disclose may indeed be found by the trier of fact to be material under Delaware law. (129)

The defendants also argued that any alleged misrepresentations or omissions after the original buy-sell agreement in October 1995 should be disregarded as irrelevant, because Neubauer had at that time already reached his decision to sell his shares, and thus, any misrepresentations or omissions could not have affected his decision to sell. The court rejected this argument, holding that “each renegotiation of the sale price during [the period between the original October 1995 execution of the option agreement and the July 1996 final amendment] triggered a new duty of complete candor on the Goldfarbs’ part.” (130)

This case points out that no amount of drafting can shield directors and majority shareholders from the consequences of a failure to disclose material facts, or the misrepresentation of material facts, in connection with the acquisition of stock from minority shareholders.

Erickson v. Centennial Beauregard Cellular, LLC (Disclosure Duties in Short-Form Merger)

In Erickson v. Centennial Beauregard Cellular, LLC, (131) the Delaware Court of Chancery declined to dismiss plaintiff’s claims that a controlling stockholder violated its fiduciary duty of disclosure to minority stockholders in connection with a short-form merger of its controlled subsidiary The court held that the plaintiff’s claims had substantial merit and suggested that plaintiff would have been entitled to summary judgment but for the defendant’s laches claim. (132) The Erickson decision emphasizes that the fiduciary duty of disclosure applies in the context of short-form mergers under section 253 of the Delaware General Corporation Law, even though a controlling stockholder is not required to demonstrate entire fairness in that context. The decision also provides guidance as to the types of information that should be disclosed to minority stockholders in connection with such a merger in order that they may make a fully informed decision whether to exercise appraisal rights.

The plaintiff, Richard Erickson, was a minority stockholder of Alexandria Cellular License Corporation (“ACLC”). Erickson and fourteen other stockholders had been cashed out in a short-form merger of ACLC with and into its controlling stockholder, Alexandria Corporation, under section 253 of the Delaware General Corporation Law. Alexandria Corporation was the predecessor in interest to defendant Centennial Beauregard Cellular LLC. Plaintiff claimed that Alexandria Corporation had violated its fiduciary duty of disclosure in connection with the merger by providing insufficient valuation information to the minority stockholders. The only valuation information that Alexandria provided to the minority stockholders was a one-and-a-half page document that contained a brief description of a precedent transaction analysis, a discounted cash flow analysis, and two charts. Both valuation methodologies were calculated based upon ACLC’s EBITDA for an unspecified period of time during 1999. No current or historic financial statements were provided and no description of ACLC’s business was provided.

The Court of Chancery explained that section 253 of the Delaware General Corporation Law provides a summary procedure by which a parent corporation that owns ninety percent or more of a subsidiary can unilaterally cause a merger to cash out minority stockholders. (135) The “Delaware courts do not entertain entire fairness claims or allegations of unfair dealing” in connection with such mergers. (134) The court emphasized, however, that the parent corporation’s fiduciary duty of full disclosure still applies in the context of such mergers. (135) “[A]ll information material to the decision [of minority stockholders] to accept the merger consideration or to seek” a statutory appraisal of their shares must be disclosed. (136) According to the court, a minority stockholder “may have an even greater need for full disclosure precisely because elements of procedural fairness are missing.” (137)

The court denied defendant’s motion to dismiss, finding that plaintiff’s disclosure claims had “substantial merit” because the defendant corporation provided “nothing more than a one-and-a-half page ‘Valuation’ based entirely upon the calculation of a single multiple lacking any supporting data.” (138) Nevertheless, the court declined to grant summary judgment to the plaintiff because he waited to file a complaint until nearly three years after the merger closed. (139) Consideration of defendant’s laches defense would require a more fully developed factual record. (140)

With respect to plaintiff’s specific disclosure claims, the court agreed that current and historical financial statements should have been provided to the minority stockholders, especially in view of the fact that ACLC was a private corporation and its basic financial information was not publicly available. (141) The court explained that the defendant’s disclosure of only a precedent transaction analysis and a discounted cash flow analysis was not sufficient. (142) Both were based on a single EBITDA calculation for an unspecified period of time. According to the court, the defendant’s disclosures were so sparse that disclosure of ACLC’s recent or historical financial statements would have altered the total mix of information in a significant way. (143)

The court also agreed with the plaintiff that a description of ACLC’s business and some indication of its revenue projections were necessary to enable minority stockholders to decide whether to seek appraisal. (144) Again, the court emphasized that this type of information about ACLC was not publicly available and that stockholders “may not have even had a rudimentary understanding of” the company’s products and services or management’s views of the company’s future prospects. (145) The discounted cash flow analysis alone, devoid of any substantive current or future financial data, was insufficient disclosure of ACLC’s future prospects. (146) The court also declined to dismiss plaintiff’s claims that other valuation data, such as the population area covered by ACLC’s cellular license and additional information regarding revenues and expenses, should have been provided to the minority stockholders. (147) The court recognized that “[a]lthough minority shareholders in a short-form merger are not entitled to every conceivable methodology to value their shares,” at least some additional indication of ACLC’s value was necessary where the information that was disclosed was so sparse. (148)

Erickson reminds practitioners of the importance of full disclosure in the short-form merger context, and also provides useful guidance as to the types of information a Delaware court might require a controlling stockholder to disclose in that context so that minority stockholders can make an informed decision whether to exercise appraisal rights.


Bielagus v. EMRE of New Hampshire Corp. (Substantial Continuation Theory Rejected by New Hampshire Supreme Court)

Bielagus v. EMRE of New Hampshire Corp. (149) involved a review by the New Hampshire Supreme Court of a judgment holding that the buyer under an asset purchase agreement was not liable for an unsecured debt of the seller. The plaintiffs were the holders of an unsecured promissory note executed by Norwood Realty, Inc. (“Norwood”) in 1986. The note was one part of a financing package used to purchase the commercial real estate division of the Norwood Group, Inc. In 1992, Norwood defaulted on the note. In March 1995, Norwood agreed to sell its residential real estate business assets, including its trade name, to EMRE of New Hampshire Corp. (“EMRE”).

Under the asset purchase agreement, EMRE agreed to pay Norwood $675,000 for assets, and EMRE assumed substantially all of the operating expenses and accounts payable that related to the assets. The agreement disclosed the existence of plaintiff’s lawsuit on the note but EMRE expressly disclaimed any liability for the note.

After purchasing the assets, EMRE “operated from the same New Hampshire branch offices with substantially the same … real estate brokers” and officers as Norwood’s former residential real estate division. (150) After the sale, Norwood used the proceeds to satisfy its secured debt but had insufficient funds remaining to pay the note. Norwood did not dissolve but began operating under a different trade name. The trial court ruled that EMRE was not liable for the note under either the “mere continuation” or the “de facto merger” theory of successor liability. (151)

The plaintiffs appealed, challenging the trial court’s ruling in favor of EMRE. EMRE asked that the court rule that the “substantial continuity” doctrine stated in Kleen Laundry & Dry Cleaning v Total Waste Management (“Kleen”), (152) does not apply to commercial contract cases in New Hampshire. The court analyzed the facts to determine whether EMRE should be held liable under either the de facto merger or mere continuation doctrines of successor liability.

The court refused to apply the “continuity of enterprise” or “substantial continuation” theory of successor liability, which had been employed by the trial court. (153) This theory does not require proof of continuity of ownership

The court held that this expanded exception to the laws of successor liability is not applicable when dealing with traditional commercial contracts for the sale of corporate assets. (155) Furthermore, the court rejected the statements of the court in Kleen that New Hampshire generally follows the substantial continuity theory, explaining that the substantial continuity theory has only been used in limited circumstances in New Hampshire, to achieve the remedial public policies relating to environmental clean-up, labor relations, and tort law. (156) The court firmly stated that New Hampshire has not adopted the substantial continuity exception policy of risk spreading. (157)

Under the de facto merger analysis, the court listed the following non-exclusive factors to be considered when determining whether a purported sale is a de facto merger:

(1) There is a continuation of the enterprise[‘s seller] so that there is continuity of management, personnel, physical location, assets, and general business operations.

(2) There is a continuity of shareholders which results from the purchasing corporation paying for the acquired assets with shares of its own stock, [which] ultimately com[e] to be held by the shareholders of the seller corporation so that they become a constituent part of the purchasing corporation.

(3) The seller corporation ceases its ordinary business operations, liquidates, and dissolves as soon as legally and practically possible.

(4) The purchasing corporation assumes those obligations of the seller ordinarily necessary for [an] uninterrupted continuation of normal business operations…. (158)

The court observed that “[t]he factor that usually ‘tips the scales in favor of finding a [de facto] merger is continuity of ownership, [which] usually tames] the form of an exchange of stock for assets.” (159) The court noted that in this case there was no continuity of shareholders and that Norwood “did not cease its ordinary business operations and liquidate.” (160) Finally, the court stated that there were no allegations that inadequate consideration was paid. (161) Thus, the court upheld the trial court’s finding that a de facto merger had not occurred. (162)

Under the mere continuation theory, the court noted that a corporation should not be held liable as the continuation of a predecessor “unless only one corporation remains after the transfer of [the] assets and unless there is an identity of stock, stockholders and directors between the two corporations.” (163) Although “continuity of ownership is the key factor for imposing successor liability under” the traditional continuation exception, the court noted that some courts also consider adequacy of consideration and whether the sale was made in good faith. (164)

Because three distinct entities with different owners existed after this sale, the court held that such existence precluded successor liability from being applied under the mere continuation theory. (165)

Cargo Partner AG v. Albatrans (De Facto Merger Theory Requires Continuity of Ownership)

In Cargo Partner AG v. Albatrans, (166) the court addressed the requirements for the application of the de facto merger doctrine under New York law, and concluded that continuity of ownership by the seller must be present for the doctrine to apply.

Cargo Partner involved a derivative action in which the plaintiff, Cargo Partner, alleged that Chase, Leavitt (Customhouse Brokers) Inc. (“Chase”) owed it approximately $240,000 for services rendered. A second defendant in the action was Albatrans, Inc., which had acquired all of Chase’s assets. The agreement for the acquisition of assets provided that Chase would provide customs brokerage services for Albatrans until Albatrans could acquire its own customs brokerage license, and that Chase would operate as a profit center within Albatrans, using the assets it had sold to Albatrans. Chase’s sole shareholder agreed to continue in its employ until Albatrans obtained its license, and to indemnify Albatrans for any breach of Chase’s obligations under the agreement and for any liabilities of Chase incurred before execution of the agreement.

Cargo Partner asserted that Albatrans was liable for Chase’s alleged debt to Cargo Partner for services rendered on the ground, among others, that there had been a de facto merger of Chase and Albatrans. Adopting the recommendation and report of a magistrate judge, the U.S. District Court for the Southern District of New York dismissed the complaint. (167) Magistrate Judge Eaton’s recommendation and report, attached to the district court’s opinion, includes a comprehensive survey of the development of successor liability. With respect to the successor liability count of the complaint, the district court certified, for interlocutory appeal, the question whether the New York Court of Appeals would require that a plaintiff seeking application of the de facto merger doctrine plead all four applicable factors. (168)

The four factors generally identified by courts as indicating that an asset acquisition is equivalent to a merger, and therefore should be treated as one, are: “[i] a continuity of the selling corporation, evidenced by the same management, personnel, assets and physical location

On appeal, Cargo Partner conceded that it lacked any factual basis to plead continuity of ownership, but argued on the basis of an opinion of the Appellate Division that de facto merger can be applied under New York law without all four factors being present. The U.S. Court of Appeals for the Second Circuit saw no need to determine whether all four factors are required, because it was “confident that the doctrine of de facto merger in New York does not make a corporation that purchases assets liable for the seller’s contract debts absent continuity of ownership.” (170) The court characterized continuity of ownership as the essence of a merger. (171) It acknowledged that a number of states have relaxed the continuity of ownership requirement in product liability cases, but noted that this had not been done outside of the products liability context. (172) Magistrate Judge Eaton’s recommendation and report, after a comprehensive review of the development of successor liability doctrines, distinguishes trade creditor claims from product liability claims on policy grounds, pointing out that in any specific case, giving creditors of an insolvent seller a claim against the buyer (assuming the solvency of the buyer) would give them a windfall, and that in the long run, the imposition of expanded successor liability to trade creditors would make it more difficult for an insolvent business to be sold as a going concern, thus increasing the likelihood of a piecemeal sale of assets at a lower price and thus reducing the amount available to creditors. (173)

New York v. National Services Industries, Inc. (Substantial Continuity Test Abandoned for Determining Successor Liability under CERCLA)

In New York v. National Services Industries, Inc., (174) the court determined that the “substantial continuity” test that it had adopted in 1996 for successor liability under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (“CERCLA”) (175) should no longer be used for that purpose. (176)

The issue in National Services Industries was the appropriate test for successor liability under CERCLA. In B.F. Goodrich v. Betkoski, (177) the court held that, in determining whether a corporation that purchased the assets of a company liable for environmental response costs under CERCLA should be held liable for those same costs, the test should be substantial continuity (sometimes referred to as the continuity of enterprise approach), a test the Supreme Court had followed in the labor law context. (178) This test focuses on whether “the successor maintains the same business, with the same employees doing the same jobs, under the same supervisors, working conditions, and production processes, and produces the same products for the same customers.” (179) In its opinion in National Services Industries, the court recognized that Betkoski did not apply general common law principles of corporate law, but rather adopted “a special rule for use in CERCLA cases that departed from those principles.” (180)

The defendant in National Services Industries, which had purchased assets of an industrial garment rental business, was held liable by the U.S. District Court for the Eastern District of New York under CERCLA for cleanup costs at a landfill at which its seller had deposited liquid waste containing a solvent used in dry cleaning. The district court held that the defendant’s operations were a substantial continuation of the business of its predecessor. On appeal, the defendant argued that the substantial continuity test adopted in Betkoski was no longer good law after the Supreme Court’s opinion in United States v. Bestfoods. (181) In that case, the trial court held that Bestfoods had liability under CERCLA because it had “operated” a facility through a subsidiary by selecting the subsidiary’s board and populating its executive ranks with Bestfoods officials, (182) The Supreme Court stated that the failure of CERCLA “to speak to a matter as fundamental as the liability implications of corporate ownership demands application of the rule that [i]n order to abrogate a common-law principle, the statute must speak directly to the question addressed by the common law.” (183)

In National Services Industries, the court read Bestfoods as holding that, in determining the appropriate rule for successor liability under CERCLA, courts “must apply common law rules and not create CERCLA–specific rules.” (184) Betkoski, the court held, was no longer good law because the substantial continuity test departs from the common law rule that a corporation acquiring the assets of another corporation takes on its liabilities only if (i) it agrees to assume them

Judge Leval wrote a concurring opinion, agreeing that the substantial continuity test could not survive the Supreme Court’s opinion in Bestfoods, but noting that, in his view, the district court had misapplied that test.(187) His concurring opinion reviews some significant differences between the application of the substantial continuity test in labor law cases and its possible application in the context of environmental liability.

* Scott T. Whittaker, co-hair, is a member of the Louisiana Bar and practices law with Stone Pigman Walther Wittmann, LLC in New Orleans, Louisiana. Jon T. Hirschoff, co-chair, is a member of the Connecticut Bar and practices law with Finn Dixon & Herling, LLP in Stamford, Connecticut. Contributors: Patrick J. Leddy is a member of the Ohio Bar and practices law with Jones Day in Cleveland, Ohio

(1.) 325 F.3d 174 (3d Cir. 2003), cert. denied, 124 S Ct. 805 (2003), and cert. denied, 124 S. Ct. 812 (2003).

(2.) Id. at 180-81.

(3.) Id. at 175.

(4.) 91 F.3d 337 (2d Cir. 1996).

(5.) AES Corp. v Dow Chem. Co., 157 F. Supp. 2d 346, 353-54 (D. Del. 2001).

(6.) Id. at 354.

(7.) AES Corp, 325 F.3d at 184

(8.) Id. at 181.

(9.) 540 F.2d 591,598 (3d Cir. 1976).

(10.) AES Corp., 325 F.3d at 178-79.

(11.) Id. at 180.

(12.) 361 F.2d 260 (1st Cir. 1966).

(13.) AES Corp., 325 F.3d at 180-81.

(14.) Id. at 181.

(15.) Id.

(16.) Id. at 184.

(17.) 281 E Supp. 2d 814 (E.D. Va. 2003), aff’d, 2004 U.S. App. LEXIS 5861 (4th Cir. Mar. 30, 2004).

(18.) 249 F. Supp. 2d 387 (S.D.N.Y. 2003).

(19.) No. 02 Civ. 7689(HB), 2003 WL 22795650 (S.D.N.Y. Nov. 25, 2003).

(20.) 281 F. Supp. 2d 814 (E.D. Va. 2003).

(21.) Id. at 817, 822.

(22.) Id. at 821 (quoting Foremost Guar. Corp. v Meritor Say Bank, 910 F.2d 118, 123-24 (4th Cir. 1990)).

(23.) Id. at 822.

(24.) Id. at 827.

(25.) 249 F. Supp. 2d 387 (S.D.N.Y. 2003).

(26.) Id. at 407.

(27.) Id. at 402.

(28.) Id. at 409.

(29.) Id. at 422.

(30.) No. 02 Civ. 7689(HB), 2003 WL 22795650 (S.D.N.Y. Nov. 25, 2003).

(31.) Id. at *7.

(32.) Id. at *1.

(33.) Id. at *3 n.4.

(34.) Id. at *3.

(35.) Id. at *2.

(36.) See supra notes 25-29 and accompanying text.

(37.) See supra note 4.

(38.) Allegheny, 2003 WL 22795650, at *5.

(39.) Id.

(40.) Id. at *7.

(41.) Id at *5.

(42.) Id.

(43.) 57 F.3d 146, 155 (2d Cir. 1995).

(44.) Allegheny, 2003 WL 22795650, at *6.

(45.) Id

(46.) Id

(47.) Id.

(48.) Id.

(49.) Id. at *7.

(50.) Id.

(51.) Id.

(52.) Id.

(53.) Id.

(54.) Id. (quoting Carmeuse v. M.J. Stavola Indus., Inc., 823 F. Supp. 125, 131 (S.D.N.Y. 1993)) (alteration in original).

(55.) No. 02 Civ.7939 RO, 2003 WL 21511921 (S.D.N.Y July 2, 2003).

(56.) Id. at *2.

(57) Id.

(58.) Id.

(59.) Id.

(60.) Id. at *3.

(61.) 244 F. Supp. 2d 1250 (D. Kan. 2003).

(62.) Id. at 1263.

(63.) Id. at 1255.

(64.) Id. at 1260.

(65.) Id.

(66.) Id.

(67.) Id. at 1257.

(68.) Id. at 1258.

(69.) Id. at 1257-58 (footnote omitted).

(70.) Id at 1259.

(71.) Id.

(72.) Id.

(73.) Id. at 1260-61.

(74.) Id. at 1263.

(75.) Id. at 1267.

(76.) Id

(77.) Id. at 1268.

(78.) Id. at 1278.

(79.) 794 N.E.2d 667 (N.Y. 2003).

(80.) Id. at 668.

(81.) Id. at 670.

(82.) Id. at 668.

(83.) Id. at 671.

(84.) Id.

(85.) Id.

(86.) Id.

(87.) Id.

(88.) Id. at 671-72.

(89.) 320 F.3d 714 (7th Cir. 2003).

(90.) Id. at 717.

(91.) Id. at 723.

(92.) Id. at 717 (alteration in original)

(93.) Id. at 721.

(94.) Id.

(95.) Id.

(96.) Id.

(97.) Id. at 723.

(98.) Id.

(99.) 327 F.3d 30 (1st Cir. 2003).

(100.) Id. at 37.

(101.) Id. at 38-39.

(102.) Id. at 40 (internal quotation marks omitted).

(103.) Id. On the distinction between the duties of publicly traded and closely held corporations for these purposes, see the opening paragraphs of Judge Easterbrook’s opinion in Jordan v. Duff and Phelps, Inc., 815 F.2d 429, 431 (7th Cir 1987).

(104.) Lawton, 327 F.3d at 41.

(105.) Id. at 41-42.

(106.) Id. at 41.

(107.) Id. at 51.

(108.) Id. at 43 44.

(109.) Id. at 46-47.

(110.) Id at 47.

(111.) Id.

(112.) Id

(113.) Id. at 48.

(114.) Id.

(115.) Id. (quoting Rowe v. Maremont Corp., 850 F.2d 1226, 1241 (7th Cir. 1988)) (internal quotation marks omitted).

(116.) Id. at 49.

(117.) 133 Cal. Rptr. 2d 218 (Cal. Ct. App. 2003)

(118.) Id. at 225.

(119.) Id. at 231.

(120.) Id. at 227.

(121.) Id. at 228.

(122.) Id at 223-26.

(123.) Id. at 221.

(124.) Id. at 223, 227.

(125.) Id. at 224 (quoting Cohen v. Kite Hill Cmty. Ass’n, 191 Cal. Rptr. 209, 216 (Cal. Ct. App. 1983)).

(126.) Id. (quoting Cohen, 191 Cal. Rptr. at 216) (alteration in original).

(127.) Id. at 226.

(128.) Id.

(129.) Id. at 231.

(130.) Id. at 233.

(131.) No. Civ.A. 19974, 2003 WL 1878583 (Del. Ch. Apr. 11, 2003).

(132.) Id. at *6, *9.

(133.) Id. at *4.

(134.) Id.

(135.) Id.

(136.) Id. at *4-*5.

(137.) Id. at *5.

(138.) Id. at *6.

(139.) Id. at n. 31.

(140.) Id. at *6.

(141.) Id.

(142.) Id.

(143.) Id.

(144.) Id. at *7.

(145.) Id.

(146.) Id.

(147.) Id. at *8.

(148.) Id.

(149.) 826 A.2d 559 (N.H. 2003).

(150.) Id. at 563.

(151.) Id.

(152.) 817 F. Supp. 225 (D.N.H. 1993).

(153.) Bielagus, 826 A.2d at 568-69.

(154.) Id. at 568.

(155.) Id.

(156.) Id.

(157.) Id. at 569.

(158.) Id. at 565-66.

(159.) Id. at 566 (quoting Devine & Devine Food Brokers, Inc. v. Wampler Foods, Inc., 313 F.3d 616, 619 (1st Cir. 2002)) (internal quotation marks omitted).

(160.) Id.

(161.) Id. at 567.

(162.) Id.

(163.) Id. (quoting Kleen Laundry, & Dry Cleaning v. Total Waste Mgmt. Corp., 817 F. Supp. 225, 231 (D.N.H. 1993)).

(164.) Id. at 568.

(165.) Id. at 569.

(166.) 352 F.3d 41 (2d Cir. 2003).

(167.) Cargo Partner AG v Albatrans, Inc., 207 F. Supp 2d 86, 90-91 (S.D.N.Y. 2002).

(168.) 352 F.3d at 44.

(169.) 207 F. Supp. 2d at 97 (quoting Ladjevardian v. Laidlaw-Coggeshall, Inc., 431 F. Supp 834, 839 (S.D.N.Y. 1977)) (emphasis omitted).

(170.) 352 F.3d at 46.

(171.) Id. at 47.

(172.) Id.

(173.) 207 F. Supp. 2d at 112. For additional policy considerations relevant to successor liability in the products liability context, see RONALD J. GILSON & BERNARD S. BLACK, THE LAW AND FINANCE OF CORPORATE ACQUISITIONS 1505–08, 1532-41 (2d ed. 1995).

(174.) 352 F.3d 682 (2d Cir. 2003).

(175.) 42 U.S.C. [subsections] 9601-9675 (2000).

(176.) 352 F.3d at 684.

(177.) 99 F.3d 505 (2d Cir. 1996).

(178.) Id. at 519.

(179.) Id.

(180.) 352 F.3d at 685-86.

(181.) 524 U.S. 51 (1998).

(182.) Id. at 59.

(183.) Id. at 63 (quoting U.S. v. Tex., 507 U.S. 529,534 (1993)) (internal quotation marks omitted) (alteration in original).

(184.) Nat’l Servs. Indus., Inc., 352 F.3d at 685.

(185). Id.

(186.) Id. at 687.

(187.) Id. at 687-88 (Leval, J., concurring).