The Delaware Court of Chancery’s recent decision in The Williams Companies v. Energy Transfer Equity, L.P., C.A. Nos. 12168, 12337-VCG (Del. Ch. June 24, 2016), authorizing Dallas-based Energy Transfer Equity (ETE) to terminate its merger agreement with Tulsa-based Williams Companies—a deal initially valued at $38 billion before depressed oil prices caused the deal value to plummet—has caused many to question whether the ruling will have a chilling impact on deal certainty by allowing judicially sanctioned buyers’ remorse. The opinion, however, actually reinforces basic principles for deal lawyers and litigators: The merger agreement must clearly and unequivocally provide the bases for termination and the parties’ related rights. If closing preconditions are clearly outlined, the court will honor contractual terms and will not substitute its own judgment over the parties’ mutually agreed terms.
Background of the Merger Agreement
On September 28, 2015, ETE and Williams entered into a merger agreement for Williams to merge into a subsidiary of ETE in a mixed-consideration transaction. Under the terms of the merger agreement, each Williams stockholder could elect to receive as consideration for each share (1) cash; (2) common shares of Energy Transfer Corp. L.P. (ETC), ETE’s affiliate; or (3) a combination of cash and ETC shares. The merger was subject to several conditions, including the issuance of an opinion by ETE’s tax attorneys at Latham & Watkins LLP that the transactions subject to the merger “should” be treated as a tax-free exchange under section 721(a) of the Internal Revenue Code. This condition was not surprising given that ETE is a publicly traded partnership (referred to as a “master limited partnership” or MLP) that is structured to be treated as a tax pass-through entity. Jeffrey Oliver, “Master Limited Partnerships and Merger Review: A Unique Form Meriting Careful Analysis,” 9 Tex. J. Oil, Gas & Energy 357 (2014).
The merger agreement was the culmination of a tumultuous, months-long courtship beginning in February 2014 when ETE actively sought a strategic combination with Williams. Prior to executing the September 2015 merger agreement with ETE, the Williams board of directors had rejected multiple offers from ETE, approved a strategic combination with its MLP affiliate Williams Partners, LP, and faced mounting criticism and lawsuits from its shareholders challenging the board’s decisions and the direction of the company. See Nicholas Sakelaris, “Why the Williams Company Publicly Rejected Energy Transfer Equity’s 53B Deal,” Dallas Bus. J., June 22, 2015; Maya Rajamani, “Williams Cos. Rejects ETE’s 53B Merger Proposal,” Law360, June 22, 2015 (log-in required); Kurt Orzeck, “Williams Cos. Brass Sued for Snubbing $53B ETE Merger Offer,” Law360, July 1, 2015 (log-in required).
When ETE and Williams finally announced that they had reached an agreement to form one of the world’s largest energy infrastructure operators, it appeared the parties’ relationship was on the mend. But declining oil prices in the fourth quarter of 2015 began to quickly erode the value of the deal and put pressure on ETE to generate the $6.05 billion in cash that it was obligated to pay in connection with the deal.
By early 2016, numerous public reports highlighted the mounting troubles with the merger. Casey Smith, “WMB Shareholder Files Class Action Lawsuit Against Williams, ETE,” Tulsa World, Jan. 16, 2016. The strained relationship between ETE and Williams was exacerbated when ETE conducted a private offering in March 2016, which ETE stated was necessary to generate cash to pay debt to close the deal. Williams, which had previously rejected ETE’s proposal to hold a public offering and did not participate in the private offering, construed the private offering as a breach of the merger agreement that placed certain ETE unitholders in a preferential position over the Williams stockholders. In April 2016, Williams sought to unwind the private offering by suing ETE in Delaware for breach of contract, and it sued ETE’s chairman and chief executive officer (CEO) in Texas for tortious interference. In a third lawsuit, filed in May 2016, Williams again sued ETE in Delaware in connection with ETE’s failure to secure the required tax opinion, asserting that ETE failed to use commercially reasonable efforts to obtain the tax opinion and therefore could not use inability to obtain the opinion as a basis to terminate the merger agreement.
Summary of the Court’s Opinion
After a two-day trial, on June 24, 2016, Vice Chancellor Glasscock of the Delaware Court of Chancery issued his opinion and concluded that ETE was entitled to terminate the merger agreement because tax counsel was unable to issue the tax opinion. The substantial decline in ETE’s units due to the slump in oil prices meant that Latham could not conclude with reasonable certainty that the transfer of assets to ETE would be treated as tax-free. Although Williams questioned Latham’s good faith in connection with identifying the tax issue and alleged that it was improperly influenced by ETE, the court was unconvinced that ETE “materially breached its contractual obligation to undertake commercially reasonable efforts to receive [the tax opinion].” Accordingly, the court concluded that ETE could terminate the merger agreement based on its inability to obtain the required tax opinion. The court did not opine on whether ETE’s March 2016 private offering constituted a breach of the merger agreement and left that issue to be litigated further between the parties. A few days later, ETE formally terminated the merger agreement. Press Release, Williams Cos., Williams Comments on ETE’s Decision to Terminate Merger Agreement (June 29, 2016).
The court’s opinion not only reinforces the critical importance of a well-drafted agreement, but highlights the importance of a well-documented, rigorous process by all parties and their advisors. While sobering for dealmakers, the opinion provides guidance about important landmines to avoid in papering the deal.
Termination risk must be properly allocated. Deal-protection provisions are often construed from the buyer’s perspective to protect its deal from interference from third parties. Standard deal protections include break-up fees, matching rights, fiduciary-termination rights, change of recommendation, and force-the-vote provisions. To enhance deal certainty, dealmakers should craft provisions that are tailored to their client’s needs and industry factors. Such provisions should clearly state the parties’ respective rights and obligations with respect to changed market conditions and other critical aspects that form the basis of the deal. As a Delaware MLP, ETE valued a deal that was structured as tax-free—a critical structure for ETE’s unitholders. Thus, allocating the risk of failure to obtaining a tax opinion, or other key approvals, such as regulatory approval and the like, is essential.
The use of forum provisions can streamline dispute resolution. Choice-of-law and forum-selection provisions will help streamline dispute resolution in the event litigation arises. Williams strategically split its claims and separately sued ETE and its chairman and CEO in two separate jurisdictions—Delaware and Texas. ETE challenged the Texas lawsuit on a motion to dismiss based on a mandatory forum-selection clause in the merger agreement that designated Delaware as the proper forum for disputes related to the merger agreement. After the Texas court enforced the forum-selection provision, Williams dismissed its Texas lawsuit and was forced to litigate exclusively in the designated forum: Delaware.
Subjective good faith affects a “reasonable” standard. Merger agreements typically contain language that binds the parties (particularly the buyer) to a certain standard to obtain clearance to proceed with the transaction. The court will apply the contractual standard—such as “reasonable” efforts or “best” efforts. The ETE-Williams merger agreement required ETE to use “commercially reasonable efforts” to secure the tax opinion, and the court determined that ETE “submitted itself to an objective standard—that is, it bound itself to do those things objectively reasonable.” Thus, the court’s analysis turned on what ETE did to try to secure that opinion. Because ETE retained Latham to provide the tax opinion, the court scrutinized Latham’s good faith. Under a subjective good-faith standard, the reasonableness of the decision is irrelevant. The court explained:
[I]t is Latham’s subjective good-faith determination that is the condition precedent. As a result, it is not appropriate for me to substitute my judgment on the Section 721(a) issue for that of Latham; my role is to determine whether Latham’s refusal, thus far, to issue a “should” opinion is in good faith, that is, based on Latham’s independent expertise as applied to the facts of the transaction.”
Thus, Williams faced a heavy burden: It was not enough for Williams simply to point out deficiencies or flaws in Latham’s process or to question Latham’s motivations. Indeed, Latham’s expertise and reputation, coupled with the similar conclusion reached by the tax lawyers at Morgan Lewis who were also retained by ETE, lead the court to conclude that Latham had acted in good faith.
Courts will consider extra-contractual factors to construe contract terms, so a proper record is critical. The court reached its decision after evaluating trial testimony and the evidentiary record, which included board minutes, banker’s books, advisor presentations (including drafts), emails, and other documents. This approach underscores why legal advisors should assist in facilitating the deal process and creating a complete record of that process. Likewise, board minutes, presentations, and materials should be prepared promptly and should explain the reasons the board made key judgments and the advice or input on which the board relied. Board minutes should also note and explain the resolution of any concerns board members or their advisors have about the proposed transaction, whether those concerns were expressed during or outside of formal meetings. Any questions, issues, or concerns raised by any means of communication should be resolved on the record, and any changes in presentations and analyses from the board’s advisors should be specifically called out to directors by using redlines, tables reflecting key changes, and explanations for each change, method, or rationale. Documenting key advice is particularly critical in the context of litigation so that directors can rely on the recorded advice and use it in their defense in the event of litigation.