The possibility of damages for breach of contract is sometimes overlooked - or if not overlooked, under-emphasized - in M&A transactions. Many of the best-known Delaware cases focus on breach of fiduciary duty, not breach of contract.
However, several recent decisions highlight the risk and consequences of breach of contract. Breach of an acquisition agreement generally will support an award of damages to the non-breacher. Breach by a target company will not be excused simply because the board obtained a better deal for stockholders. Further, the general rule for damages is "expectancy damages proven to a reasonable certainty" - meaning, in the M&A context, that if a buyer loses a deal due to the seller's breach, the buyer's damages include the value it expected to receive from the acquisition, which could be well in excess of the sale price or the valuation given by the seller or the market.
Breach by a Target Company: No Excuses and Expectancy Damages
Although a board of directors seeking to sell the company generally has a fiduciary obligation to seek the best possible bid, Delaware law does not give the board a free pass to get out of a sale contract with a first buyer just because a second bidder has offered a higher price. As stated by the Delaware Court of Chancery in a much-watched decision on standstill agreements, "directors of the selling corporation are not free to terminate an otherwise binding merger agreement just because they are fiduciaries and circumstances have changed." In re Complete Genomics, Inc. S'holder Litig., C.A.
No. 7888-VCL (Del. Ch. Nov. 9, 2012) (quoting Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985)).
This principle was applied, and resulted in a significant damages award, in WaveDivision Holdings LLC v. Millennium Digital Media Systems, L.L.C., C.A. No. 2993-VCS (Sept. 17, 2010). There, a cable company, under pressure from its creditors, agreed to sell three of its four cable systems to a buyer that specialized in turning around such businesses. In the asset purchase agreement, the seller agreed to a strict no solicitation clause, which obligated it, in fairly typical wording, not to "initiate, solicit or encourage, directly or indirectly," any other offers and not to engage in discussions or negotiations with, or provide information to, any other bidders. This clause did not contain an exception allowing the seller to enter discussions, etc., with an unsolicited topping bidder (i.e., it did not include the sort of fiduciary qualifier often seen in merger agreements). The asset purchase agreement also included a covenant requiring seller to use its "commercially reasonable efforts" to obtain any lender consents that were necessary for the sale.
Promptly after entering into the agreement, seller engaged in negotiations with its lenders over a recapitalization transaction that management preferred to the asset sale. As a result, the lenders refused to consent to the sale and the recapitalization took place instead. The court found that the seller had breached the original asset purchase agreement by pursuing the recapitalization. It characterized as "frivolous" the argument that the breach was excused by a fiduciary duty to continue to seek a better transaction:
[I]t remains the case that Delaware entities are free to enter into binding contracts without a fiduciary out so long as there was no breach of fiduciary duty involved when entering into the contract in the first place. To generate wealth for investors, fiduciaries must be able to bind the entity to contracts. The argument that the governing body of an entity whose senior creditors press for a sales process and who act at all times in good faith and with due care cannot agree to conduct an open sales process and enter into an ensuing sales contract with the high bidder containing a no solicitation clause is frivolous.
The court then turned to damages. Rather than market value, it focused on the buyer's expectancy:
Because a buyer often intends to operate a business in a way that will change its cash flows, its expectancy damages are the profits it expected to make, if it can prove them up with reasonable certainty.
In other words, the damages owed to the non-breaching buyer included the "synergistic value" that the buyer expected to create (such as through new management, cost savings, combination of new assets with existing platform, etc.). Based on expert testimony, the court accepted a valuation based on the cash flow projections that the buyer had provided to its lenders. The court ultimately awarded damages equal to approximately 10 percent above the agreed-upon sale price.
WaveDivision is not the only case evidencing a "freedom of contract" approach. In a case involving an asset sale by a distressed REIT, Global Asset Capital, LLC v. Rubicon US REIT, Inc., C.A. No. 5071-VCL (Del. Ch. Nov. 16, 2009, the Court of Chancery issued a temporary restraining order enforcing a strict no solicitation clause in a letter of intent, which required the REIT to deal only with a first bidder rather than continue to seek alternative offers. As in WaveDivision, the court emphasized that contracts "do not have inherent fiduciary outs." Similarly, in another decision that has received some attention, NACCO Industries, Inc. v. Applica Inc., 997 A.2d 1 (Del. Ch. 2009), the court refused to dismiss breach of contract claims against a seller, and tortious interference claims against a topping bidder, where the seller and topping bidder allegedly colluded to breach no solicitation restrictions contained in a merger agreement with a first buyer. The case ultimately settled for $60 million.
"Stock Price Damages" for Breach of a Merger Agreement
The focus on expectancy damages for jilted buyers also raises the question of how such damages would be measured for a jilted seller. For example, if a buyer gets cold feet and walks away from a merger agreement - that is, breaches the agreement by refusing to close, as was seen in a spate of deals during the financial crisis a few years ago - is the seller entitled to damages based on the purchase price that its stockholders expected to receive? A well-known decision interpreting New York law held that the answer generally is "no," because the breach was only between the buyer and the target, not between the buyer and target's stockholders (who are not actually parties to the merger agreement). The answer in Delaware may well be different, however, based on the analysis in Court of Chancery decisions on buyers' attempts to walk away from deals for claimed material adverse changes, as well as statements off the bench by Chancellor Strine (compare Consolidated Edison, Inc. v. Northeast Utilities, 426 F.3d 524 (2d Cir. 2005) with In re IBP, Inc. S'holders Litig., 789 A.2d 14 (Del. Ch. 2001)). Of course, the parties may negotiate the measure of damages specifically in the acquisition agreement if they desire.
Tricky Damages Calculations Where Consent Rights Are Breached
Two other recent decisions from Delaware, both from Vice Chancellor Parsons, demonstrate the flexibility and, to some extent, unpredictability of damages in the M&A context. In the first case, Fletcher Int'l v. ION Geophysical, 2010 WL 1223782 (Del. Ch. Mar. 24, 2010), the court found that a private company violated its certificate of incorporation by issuing notes without first receiving the approval of a preferred stockholder who had negotiated for a consent right on such issuance. The court declined to rescind the issuance, reasoning that the result of rescission could be bankruptcy for the corporation, and therefore that the balance of equities did not support such relief. The court also reasoned that the non-breaching preferred stockholder could be compensated with money damages. The court suggested that such damages could be measured based on the amount that the holder "would have received in a hypothetical negotiation regarding its asserted right to consent" - in other words, how much the corporation would have had to pay the holder to consent to the deal. The case is now proceeding to trial, with the parties focused on damages under this hypothetical negotiation theory.
The focus on damages had a very different result in the second case, Zimmerman v. Crothall, 2013 WL 1092609 (Del. Ch. Jan. 31, 2013). There, the court found that a limited liability company breached its operating agreement by entering into a series of financing transactions without the consent of a particular equity holder. However, the court awarded only one dollar in nominal damages after concluding that the transactions had been on entirely fair terms and that, as a result, the equity holder had not suffered any actual damages.
In light of the other recent cases where the Delaware court was quite willing both to find a breach and to award significant expectancy damages, the "no damages because it was fair" result should not be counted on in the typical transaction. Instead, transaction planners should account for a risk of liability for breaching a contractual obligation. These cases demonstrate that Delaware is concerned about parties honoring their bargains, even if the decision makers who enter into contracts owe fiduciary duties to equity holders.