The widespread practice in private acquisitions of combining a “subsidiary merger” acquisition structure with release, indemnification, and escrow arrangements, which purport to bind the target stockholders, received a jolt from the Delaware Court of Chancery’s recent decision in Cigna v. Audax.

The merger structure, ubiquitious in acquisitions of publicly traded targets, has emerged as the structure of choice in acquisitions of private targets that have a number of non-insider stockholders from whom it is not practicable to obtain an agreement to sell their stock during the period prior to signing a definitive acquisition agreement. When preparing merger agreements in this private M&A context, the parties regularly layer in provisions that have their origin in stock purchase agreements, as opposed to public-company merger agreements, including the release, indemnification, and escrow provisions addressed by the Court. This new decision is a wake up call for acquirors to the risks that come with this approach and the care that is required to address these risks.

How did we get here? Many private companies, especially start-ups, incentivize their employees with equity and raise capital from a spectrum of sources. These companies often end up with a stockholder profile that includes numerous low level employees, some former employees, some strategic investors and a bunch of individual, fund and institutional investors that are not actively involved with governance or oversight of the company. For an acquiror that wants to enter into a definitive acquisition agreement quickly and confidentially, the idea of collecting signatures to a stock purchase agreement from each of these non-insider holders is both unappealing and impractical. Fortunately, the stockholder profile will regularly include not only this unwieldy group, but also a small number of insider holders – usually founders and venture capital funds with board seats – that hold the requisite voting power to approve and force a sale of all of the shares of the company by merger. The merger structure permits the acquiror to acquire 100% of the target company by obtaining quick approvals from the target’s board and the insider stockholders (the latter approval being available at almost all private companies by written consent in lieu of a meeting). Whether or not a target stockholder is one of those that consented to the merger, the holder’s stock is canceled at the closing by virtue of the merger and, subject to the right to pursue appraisal rights by the non-consenting holders, converted into merger consideration. Meanwhile, the acquiror wants to have the customary protections of a stock purchase agreement: broad releases from the target stockholders, an indemnity from the target stockholders for breaches of the representations and warranties about the target’s operations, and an escrow to secure at least part of these indemnity obligations. Is this asking for too much?

Tension between the Merger Structure and Private M&A Obligations of Target Stockholders. The efficiency of the merger agreement structure, in being able to squeeze out the non-insiders without their consent or involvement, has a tension with obtaining the customary post-closing protections afforded an acquiror of a privately held target. While state merger statutes provide that, with the approval of the target board and requisite stockholder vote or consent, all of the shares may be automatically converted into the merger consideration even though many holders may not have consented to the merger, no statutory mechanic exists to automatically bind all target stockholders to post-closing obligations, such as those found in the release and indemnity provisions of a stock purchase agreement, without individual consent from each such holder.

Quick fix? Undaunted by this chasm between the merger statute and the undertakings of a stock purchase agreement, practitioners regularly relied upon a solution that leveraged the customary letter of transmittal used in mergers for the exchange of a target holder’s canceled shares for the merger consideration. The letter of transmittal had traditionally been a relatively simple document whereby the target holder would confirm ownership of its shares as part of the process of transmitting the shares in exchange for the merger consideration. The clever idea these practitioners had was to bulk up the letter of transmittal, sometimes to the extent that it would go on for several pages, and turn it into an opportunity to obtain a panolopy of agreements and obligations to benefit the acquiror, the most valuable of which were releases and indemnities.

Finally, a target stockholder said, “No thanks, I’m passing on signing this burdensome letter of transmittal that would impose upon me obligations not provided for in the merger statute, but I do want my merger consideration as required by the merger statute.” Or, in other words, “Hold the obligations, but I’ll take the cash.” The Court of Chancery agreed and set forth an explanation that arguably deals a death blow to the use of the letter of transmittal as a way to resolve the tension between a merger statute and the desire to bind target stockholders with stock purchase agreement style obligations.

The obligation of the acquiror to pay the merger consideration, according to the Court, is a pre-existing duty that arises when the merger becomes effective. Nothing in the merger statute supports the idea that a target stockholder must sign up for further obligations as a condition to receipt of its merger consideration. The idea that the merger consideration is being provided in exchange for the target stockholder’s election to sign up for these new obligations cannot fly because the closing of the merger already entitles the target stockholder to this consideration. Accordingly, the requirement to execute a supercharged letter of transmittal constitutes an attempt to create a binding contract without any consideration and therefore is wholly unenforceable.

Revisiting What Constitutes Merger Consideration. Requiring target stockholders to execute an obligation-laden letter of transmittal as a condition to receipt of their merger consideration is not the only technique for addressing the disconnect between the merger structure and the imposition on target stockholders of post-closing obligations to the acquiror. An alternative is to attempt to bake these obligations into the merger agreement itself and thereby into the merger consideration itself. In other words, the right to the merger consideration comes with the limitations imposed by the obligations. The Court discusses this concept at length and concludes that there is, in certain instances, merit to this approach. Although the Court does not provide entirely precise guidance, the following principles emerge:

• Releases and Indemnities for Amounts Beyond the Merger Consideration. Obligations that are not defining limits on the actual merger consideration cannot be deemed to be part of the merger consideration and therefore will not be enforceable against target stockholders simply by virtue of the closing of the merger. Examples would include releases and undertakings to pay amounts in excess of the merger consideration. Even if these obligations are written into the merger agreement as obligations of the target stockholders, the effectiveness of the merger, by itself, is not going to be sufficient to cause these obligations to become binding on target stockholders.

• Escrows, Holdbacks and Earn-Outs. Provisions in the merger agreement for setting aside funds that would otherwise have been merger consideration – e.g., in an escrow account or as a holdback – to secure post-closing indemnity and purchase price adjustment obligations, or to function as an earn-out, should be enforceable if drafted appropriately, as these structures may be viewed as creating contingent rights of target stockholders to receive additional consideration, as opposed to new obligations. The Court does not directly rule on the enforceability of these provisions, but the dicta and precedents are supportive.

• Merger Consideration Clawbacks for Indemnity Claims and Purchase Price Adjustments. The most interesting area is subjecting the merger consideration delivered at closing to a clawback right of the acquiror – e.g., a post-closing right of the acquiror to have merger consideration returned by the target stockholder based on purchase price adjustments or indemnification claims. According to the Court, whether these clawback rights will be enforceable against target stockholders by virtue of the merger should depend on the level of visibility that the stockholders have into the likelihood and extent of the clawback right being exercised. The rationale for applying this standard is that target holders need to be in a position, in connection with the adoption of the merger agreement, where they can evaluate whether to exercise appraisal rights – the process whereby target holders may elect to forego the receipt of merger consideration and commence legal proceedings to receive a dollar amount that the court ultimately determines to be “fair value” (which may be more or less than the merger consideration specified in the merger agreement). Thus, in the Court’s view, when determining whether a clawback right is enforceable simply by being referenced as a component of the merger consideration, the key issue is whether the clawback right is, at the time of the adoption of the merger agreement, subject to sufficient parameters to permit a reasonable assessment of this right’s impact on the value of the merger consideration.

o A misguided standard. The Court’s decision to use this standard for determining the enforceabilty of indemnity clawbacks is distressing. Indemnity clawbacks, just like contingent rights to escrows, hold-backs and earn-outs, regularly do not meet the Court’s test of having to be “ascertainable, either precisely or within a reasonable range of values.” If they were, the parties would have just adjusted the purchase price up front. The ultimate impact of indemnities, escrows, hold backs and earnouts is arguably always unascertainable at the time of adoption and that is why these mechanics are used. Moreover, since the consequences of these provisions will be based entirely on representations, warranties, or financial or other metrics for the very company with which the plaintiff is already familiar as an equity investor, the Court’s efforts to protect the target stockholder from these provisions seem like an overreach.

o When applying this standard, at one end of the spectrum are post-closing clawbacks for all of the merger consideration, without limitations as to time and scope of damages, and based on potential breaches of a broad set of representations and warranties made by the target company. The consequence of imposing such a broad limitation on the merger consideration, according to the Court, is that “the value of the merger consideration itself is not, in fact, ascertainable, either precisely or within a reasonable range of values.” As a result, such a broad clawback right conflicts with the merger statute and is not enforceable as a component of the merger consideration.

o At the other end of the spectrum are post-closing clawbacks of merger consideration based on well-defined purchase price adjustment provisions that include specific financial statement-based formulas and time limitations for resolution (e.g., a typical, post-closing true-up of an adjustment to the purchase price derived from the closing balance sheet). Here, the Court’s dicta implies that this type of well-defined clawback should be enforceable, but ultimately the Court leaves the issue wide open as does the one precedent that addresses the subject and that the Court cites approvingly.

o An even more grey area is inhabited by post-closing clawbacks for indemnification and purchase price adjustment that are limited in time (e.g., a one to three year survival period) and limited in scope as to damages and the nature of the subject matter covered by the indemnification. In the case at hand, the Court let stand the acquiror’s right to clawback indemnity payments from the merger consideration payable by the non-consenting, plaintiff-stockholder to the extent these indemnity payments arise from claims for breaches of representations and warranties subject to a three year survival period and a monetary cap. But the Court provides little guidance as to why the three year limit or cap may be sufficient and notes that its decision is without prejudice to future challenges by the plaintiff.

o In sum, the Court provides insufficient clarity on the enforceability of indemnities fashioned as clawbacks of the merger consideration. For acquirors, this lack of a clear path to enforceability in the context of indemnity claims can be costly, especially in the context of settlement discussions, given the other impediments, such as factual disputes, that often make it difficult for acquirors to recover on such claims.

• Stockholder Representative Appointments. Another unsettled area noted by the Court, but not addressed, is the authorization of stockholder representatives to act post-closing on behalf of non-consenting target stockholders – e.g., in connection with defending and settling indemnification claims. Even if, by virtue of the merger alone, the right to clawback merger consideration to cover indemnity claims were enforceable, should the effectiveness of the merger automatically bind a target stockholder to the agency of the stockholder representative? Despite the efficiencies and practicality of this regularly used mechanic of a stockholder representative, the merger statute itself does not, at least on its face, appear to have a clear hook for binding a stockholder to the appointment of such a representative without the holder’s consent. This may be an area where action by the legislature would be of value. One idea for legislation would be a scheme where the target stockholders are deemed to have accepted the representative’s appointment unless they affirmatively opt out following a notice period.

Advice for Acquirors. Practitioners will be mistaken and misguiding their acquiror clients if they read this new Chancery Court decision as sending a message that use by acquirors of a merger structure when seeking private M&A style protections is inadvisable or somehow contrary to public policy. The quick fix of the letter of transmittal is off the table. But all is not lost.

• Support Agreements and Joinders. Nothing in the decision should be read to implythat broad indemnity obligations, even if implemented in the context of a merger structure, would be unenforceable as a contractual matter due to vagueness, public policy or any other reason. The Court makes clear that, even in the context of a merger structure, “individual stockholders may contract—such as in the form of a Support Agreement—to accept the risk of having to reimburse the buyer over an indefinite period of time for breaches of the Merger Agreement‘s representations and warranties.” Accordingly acquirors should keep in mind the following considerations:

o Undertakings and joinders, not just resolutions. Assure that at least all the insider stockholders, simultaneously with their execution of consents to the adoption of the merger agreement, execute express undertakings and joinders relating to releases, confidentiality, cooperation, indemnification, stockholder representative appointment and all other matters that arguably go beyond the express terms of the merger consideration. These undertakings and joinders should be in addition to their written consents to the stockholder resolutions that adopt the terms of the merger agreement, even if the terms of the merger agreement and the resolutions reflect these matters. “The merger agreement, even though approved by the consenting stockholders, remains a contract solely between the acquiror and the target company,” in the words of the Chancery Court. Accordingly, express contractual undertakings and joinders, and not the resolutions approving the merger, are the advisable means to bind the signatory stockholders.

o Leverage Drag-Along Rights, Closing Conditionality and Pro Rata Formulas. Many private companies already have investor and stockholder agreements in place that bind their stockholders with broad drag-along obligations that require that the holders not only vote in favor of change in control transactions supported by the majority stockholders, but also sign up for all obligations ancillary to the change in control transaction. Acquirors should not overlook these valuable rights buried within investor and stockholder agreements, which agreements are typically otherwise irrelevant to the acquisition transaction. A well-advised acquiror should obligate targets and their insider stockholders to use the period between signing and closing to enforce these drag-along rights and otherwise exert efforts to cause the noninsiders to execute undertakings to comply with the indemnity and other provisions of the merger agreement that purport to bind target stockholders. In addition, acquirors should consider beefing up their merger agreements to include receipt of these executed undertakings from all or at least a minimum percentage of the non-insider stockholders as one of the conditions to closing. A further mechanic to protect the acquiror and cause the insider stockholders to obtain these undertakings is to provide for the following adjustment to the pro rata formula that specifies how the indemnity obligations are allocated among the target stockholders. Rather than allocating the indemnity obligations pro rata based on the respective portions of the merger consideration received by each stockholder relative to the aggreate consideration received by all stockholders as would be customary, acquirors should consider insisting upon allocation of these obligations pro rata relative only to the pool of stockholders that have signed undertakings or joinders to be bound contractually by the indemnity. Thus, for example, if stockholders representing only 85% of the shares have agreed to be bound by the indemnity, that group should be fully responsible for 100% of the indemnification obligations not covered by escrow. This approach is particularly important in the case of indemnities for breaches of “fundamental” representations and warranties, which are often uncapped and of indefinite duration.

• Draft the Merger Agreement to Enhance Enforceability. In the absence of separate undertakings and joinders, acquirors can increase the chances of enforceability of target stockholder obligations by drafting merger agreements in a manner that makes clear that these obligations are part of the merger consideration and that they are subject to parameters.

o Contingent Rights to Merger Consideration, Not Post-Closing Set-Asides. Amounts that are set aside for future release to the target stockholders pursuant to escrow, holdback and earn-out provisions should be described as amounts to which the target stockholders have contingent rights that are part of their merger consideration, as opposed to amounts that are set aside or taken back a moment in time after the merger consideration is determined and payable.

o Converting Clawback Rights into Contingent Rights to Merger Consideration. If, as the Court implies, contingent rights to escrow, hold-backs and earn-outs are not problematic, while indemnities fashioned as clawbacks need to meet the troublesome “reasonably ascertainable value” standard, it may be worthwhile for acquirors to structure the merger consideration in a manner that effectively converts the indemnity clawback into a contingent right.

 For example, a merger agreement could provide for a contingent right to escrowed funds with all or part of the escrowed funds being released if and when the target stockholder executes a joinder to the indemnity.

 Another idea would be for the acquiror to enter into an arrangement to purchase insurance with coverage equivalent to what would otherwise be covered by an indemnity from the target stockholders. The cost of the insurance would be deducted from the cash portion of the merger consideration, but the merger consideration would include a right to additional merger consideration (equal to each target stockholder’s pro rata portion of the cost of the insurance) contingent upon a stockholder’s execution of a pro rata indemnity undertaking. The insurance arrangement would similarly provide for reduction of the insurance cost and coverage on a pro rata basis as the direct indemnity undertakings are executed and delivered.

o Clawback Rights Baked into the Merger Consideration. In any event, obligations to pay indemnification and purchase price adjustment amounts should be referenced in the section that provides for the delivery of the merger consideration. In addition, they should be described as obligations that give rise to clawback rights of the acquiror against the merger consideration and as integral components of and limitations on the merger
consideration.

o Time Limitations. Acquirors should consider inclusion of time limitations on all obligations of the target stockholders that give rise to clawback rights against the merger consideration, even if they are simply restatements of the applicable statute of limitations. The greater the challenges the acquiror will face in obtaining contractual undertakings from target stockholders, the more advisable to include meaningful time limitations to enhance the likelihood of enforceability without these separate undertakings.

The merger structure should continue to provide an effective means for acquirors to proceed quickly and confidentially to a definitive acquisition agreement with privately held targets that locks in the target to a sale of 100% of the equity, especially when these targets have numerous non-insider stockholders. A well-advised acquiror should be able to craft an approach to the merger agreement and ancillary support agreements in ways that do not leave the acquiror with a bleak choice between a merger agreement structure that provides inadequate post-closing protections, and a stock purchase agreement structure that is characterized by unacceptable risks of failing to acquire 100% of the equity as well as impediments from the perspectives of speed and confidentiality.