Can the Failure to Obtain a “Should” Tax Opinion from External Attorneys Invalidate a Merger?

Introduction

Even though it discusses corporate governance principles in its background, The Williams Cos., Inc. v. Energy Transfer Equity, LP case is an important federal income tax ruling.¹ Namely, the case considers whether a “should” tax opinion under section 721 could be issued supporting tax-free treatment of the transfer of the Williams Cos., Inc. (Williams) assets to Energy Transfer Equity, LP (ETE) for its Class E partnership units. Obtaining this “should” opinion was a condition precedent to the closing of the merger. ETE faced this litigation because it was unable to obtain the “should” opinion after representing that it could.

Facts

ETE sought to acquire the assets of Williams. The two-step merger involved a merger of Williams into Energy Transfer Corp. LP (ETC), a Delaware limited partnership subject to corporate taxation.

As the first step, ETE would transfer $6.05 billion in cash to ETC for 19 percent of ETC’s stock. That $6.05 billion in cash and 81 percent of ETC’s shares would be transferred to Williams shareowners in exchange for their Williams’ shares.

As the second step, ETC would contribute the Williams’ assets to ETE for newly issued ETE Class E partnership units. The Class E units and ETC shares distributed would be equal in number and close in value.

ETE represented that it would be able to get an opinion from its outside attorneys that the transaction “should” qualify for section 721 nonrecognition treatment.  During the merger’s pendency, however, the energy market plummeted and the transaction was no longer favorable for ETE. Suddenly, ETE’s internal attorneys argued that the IRS could view some of the $6.05 billion in cash as a partial payment for the Williams’ assets rather than an exchange for ETC stock. ETE’s external attorneys then no longer seemed willing to issue a “should” opinion on nonrecognition. The result was termination of the merger upon failure of this condition precedent.

Procedurally

Williams tried to enjoin ETE from terminating the merger on the grounds that ETE had breached its duties by failing to “use commercially reasonable efforts” to get the section 721 opinion and “reasonable best efforts” to initiate the merger’s closing. Williams believed ETE was estopped from terminating because of its prior representation that it knew of no facts preventing the second step from qualifying as tax-free.

The Court of Chancery denied the arguments. Williams wanted the Supreme Court to find greater responsibilities in those representations than just a negative duty not to obstruct. The key language from the merger agreement was that ETE did not “know [] of the existence of any fact that would reasonably be expected to prevent [the second step] from qualifying as an exchange to which [section] 721(a) . . . applies.”²

Ruling

Equitable estoppel is available where a party leads another to change position detrimentally because of reliance on that original party. As ETE became concerned about getting the “should” opinion, Williams argued that nothing had changed. Nevertheless, ETE did not fail in its obligation to disclose any facts known at the time of the merger agreement. The Supreme Court found that only the external firm’s opinion had changed. Nothing shows that the external firm did anything but act in good faith reliance on the information available. While ETE may have wanted to use the lack of ability to get a “should” opinion as an excuse from completing a then-unprofitable combination, there is nothing to show collusion between ETE and the external firm. Accordingly, the Delaware Supreme Court upheld the Court of Chancery’s opinion allowing ETE to terminate the merger.

Implications

Given the specificity of the opinion condition precedent in the merger agreement at stake in the Williams case, it was perhaps too easy for ETE to get out of the deal once it turned unprofitable for it. There is always some amount of subjectivity in the level of opinion a firm is willing to provide. Tax attorneys on these kinds of deals may want to weigh carefully whether it is necessary to include a high level of opinion certainty as a merger condition.

Merger termination fees are generally quite large. Because of the Williams case, firms that provide tax opinions for mergers and similar transactions may need to review their determinations of proper malpractice insurance coverage.

Although there was a dissent in the case, the vote was 4 to 1, suggesting that the dissent is relatively unimportant for immediate purposes. The case does illustrate basic corporate governance principles in the hotbed for corporate governance that Delaware is.  It provides insight into the approaches internal and external tax advisers may take in a merger and the consequences for the parties. ■