On March 23, 2017, the Delaware Supreme Court, in a 4-to-1 decision, affirmed the Court of Chancery’s denial of The Williams Companies, Inc.’s (Williams) request for a judgment requiring Energy Transfer Equity, L.P. (ETE) to close a merger agreement to acquire Williams at a price initially valued at more than $30 billion. The case turned on whether a contractual condition to closing — that the law firm Latham & Watkins, ETE’s tax counsel, furnish an opinion that the contribution of Williams’ assets to ETE should be treated as a tax-free exchange — had validly failed to occur.1
The Supreme Court determined that the Court of Chancery had failed to properly analyze whether ETE breached its covenants to use “commercially reasonable efforts” to obtain the tax opinion and “reasonable best efforts” to close the deal. Nevertheless, the Supreme Court majority held, ETE met its burden of proving that any alleged breach of the covenants did not materially contribute to the failure of the tax opinion closing condition. In a lengthy dissent, Chief Justice Strine criticized the Supreme Court majority for accepting the Court of Chancery’s “terse conclusion” that the failure to issue the tax opinion was not influenced by ETE’s conduct. He pointed to ETE’s desire to back out of the deal and referred to several examples of “covenant-breaching behavior” by ETE that put “undue professional pressure” on Latham not to issue the tax opinion, in violation of ETE’s duties under the merger agreement.
In September 2015, ETE and Williams entered into a two-step merger agreement under which Williams would merge into a specially-created ETE affiliate, Energy Transfer Corp LP (ETC), and the stockholders of Williams would receive stock in ETC and $6.05 billion in cash. ETC would fund the cash portion of the acquisition consideration by issuing some of its stock to ETE. Upon completion of the first-step merger, ETC would then transfer all the former Williams assets to ETE in exchange for ETE partnership units. The former Williams stockholders would end up owning (in addition to the $6.05 billion) approximately 81 percent of ETC’s stock.
A critical economic premise of the transaction was that ETE’s acquisition of the Williams assets would be tax free. The merger agreement therefore required, as a material condition to closing, that Latham issue an opinion under Section 721(a) of the Internal Revenue Code (the 721 Opinion) that this second step of the transaction “should” (meaning that it quite likely would) be treated by the tax authorities as a tax-free exchange. At the time the merger agreement was signed, neither Latham nor the other counsel working on the transaction viewed this condition as problematic because the cash component of the transaction was, at that point, consideration for ETC stock of equivalent value. However, that view soon radically changed.
Shortly after the merger agreement was signed, the energy market — and the value of energy transportation assets — precipitously declined. So too did the value of ETE’s publicly traded partnership units, which dropped to between one-third and one-half of their value at signing. The ETC shares which had been valued at more than $6 billion at the time of signing, declined to approximately $2 billion. Since ETE would have to borrow against its devalued assets to pay the $6.05 billion cash portion of the consideration, the transaction became financially unpalatable to ETE, and ETE desired to avoid the proposed merger.
In early 2016, while evaluating the tax implications of the transaction for unrelated purposes, ETE’s senior tax executive had what the Court of Chancery described as an “epiphany.” He allegedly realized for the first time — six months after the merger agreement was signed — that the number of ETC shares to be exchanged was fixed rather than floating. He became concerned that the diminution of the value of the ETE partnership units to be issued to ETC (and the diminution of the ETC shares to be issued in exchange for $6.05 billion) created the risk that a portion of cash paid by ETE to ETC (the “excess” $4 billion) could be treated as consideration for the Williams assets. As a consequence, the transaction might be treated in part as a taxable exchange. ETE communicated that concern to Latham, whose tax lawyers concluded that it could no longer opine that the tax authorities “should” treat the contribution of the Williams assets for ETE partnership units as a tax-free transaction. ETE and Latham advised Williams of Latham’s conclusion, and on that basis ETE took the position, despite Williams’ objection, that it was contractually free to terminate the transaction. That impasse ultimately led to Williams bringing its Chancery action to compel ETE to complete the merger.
The Court of Chancery Opinion
Williams sought a declaratory judgment that ETE was estopped from exercising its right to terminate, on the ground that ETE had materially breached its obligation under the merger agreement to use commercially reasonable efforts to obtain the 721 Opinion from Latham. On that basis, Williams also sought an injunction precluding ETE from terminating the merger transaction. Williams’ claim rested upon its contention that Latham had arrived at its 721 Opinion determination in bad faith. The parties’ colliding positions generated the two issues that the Court of Chancery addressed in its opinion: (1) whether Latham had reached its conclusion in good faith, and (2) if so, whether ETE had materially breached its contractual requirement to make commercially reasonable efforts to obtain the 721 Opinion.
The first issue, as framed by the Court, was whether Latham had determined in “subjective good faith” that it could not issue the 721 Opinion. The Court found, as fact and based on the evidentiary record, that Latham had reached its conclusion, based upon its uninfluenced independent judgment, in subjective good faith. The factual bases for so concluding (among others) were that Latham was a law firm of “national and international repute,” that its reputational interests were larger than those of this specific representation, that its inability to issue the 721 Opinion was a “substantial embarrassment” to Latham despite its initial view that it could do so, and that upholding its reputation in the legal community outweighed any potential benefit of unethically deferring to the interests of this single client. As the Court noted, “while this deal is, certainly, a lunker, Latham has even bigger fish to fry.”
Turning to the second issue, the Vice Chancellor noted that “commercially reasonable efforts” was not defined in the merger agreement, and that “the term is not addressed with particular coherence in our case law.” Citing earlier Supreme Court precedent,2 the Court found that “commercially reasonable efforts” required the purchaser (ETE) to submit itself to an “objective standard — that is, [ETE] bound itself to do those things objectively reasonable to produce the desired 721 Opinion, in the context of the agreement between the parties.” The Court found as fact that ETE was motivated to exit the transaction if it could, and the Court “approached this matter with a skeptical eye, in light of that motivation.” But even so, “[j]ust as motive alone cannot establish criminal guilt. . . motive to avoid a deal does not demonstrate lack of a contractual right to do so.” Having reviewed the evidence, the Court concluded that Williams could “point to no commercially reasonable efforts that [ETE] could have taken to consummate the [merger]; specifically. . . actions available to [ETE] that would have caused Latham, acting in good faith, to issue the 721 Opinion. The record demonstrates no such actions available to [ETE].” Moreover, “[t]here is simply nothing that indicates. . . that [ETE] has manipulated the knowledge or ability of Latham to render the 721 Opinion, or failed to fully inform Latham, or do anything else, whether or not commercially reasonable, to obstruct Latham’s issuance of the condition-precedent 721 Opinion, or that had a material effect on Latham’s decision.”
The Court of Chancery concluded that Latham, “as of the time of trial, could not in good faith opine that tax authorities should treat the… exchange…as tax free under Section 721(a); and [that] because Williams has failed to demonstrate that [ETE] has materially breached its contractual obligation to undertake commercially reasonable efforts to receive such an opinion…[ETE] is contractually entitled to terminate the Merger Agreement, assuming [the tax counsel’s] opinion does not change before the end of the merger period. . .” The Court of Chancery granted judgment in favor of ETE in June 2016 and ETE terminated the merger agreement days later. Williams appealed to the Delaware Supreme Court.
The Supreme Court Majority Opinion
On appeal, Williams first argued that the Court of Chancery had interpreted the efforts covenants in the merger agreement too narrowly by imposing on ETE only a duty not to impede performance of the merger agreement rather than an affirmative obligation to ensure satisfaction of the 721 Opinion closing condition.3 Williams also contended that the Court of Chancery should have concluded that ETE’s conduct constituted a breach of the efforts covenants because ETE failed to comply with its affirmative best efforts obligations to obtain the 721 Opinion. Williams then argued that the Court of Chancery also erred by allocating to Williams — rather than ETE — the burden of proving that ETE’s covenant breaches materially contributed to the failure of the 721 Opinion closing condition.
The Supreme Court majority agreed that the Court of Chancery had adopted an “unduly narrow view” of the obligations imposed by the efforts covenants in the merger agreement, and had not properly analyzed whether or not ETE breached those covenants. The merger agreement covenants “placed an affirmative obligation on the parties to take all reasonable steps to obtain the 721 opinion and otherwise complete the transaction.” Thus, the Court of Chancery should have focused on actions taken affirmatively by ETE rather than a lack of proof that ETE caused Latham to withhold the 721 Opinion.
The Supreme Court majority also agreed with Williams that, if a proper analysis of ETE’s conduct led to a conclusion that ETE breached the efforts covenants, the burden should have shifted to ETE to prove that its breaches did not materially contribute to the failure of the closing condition. Even so, given the Court of Chancery’s finding that ETE’s actions or omissions did not contribute to Latham’s decision not to issue the 721 Opinion, the Supreme Court majority concluded that even if the burden of proof had been properly placed on ETE, ETE met its burden of proving that any alleged covenant breach did not materially contribute to the failure of the 721 Opinion closing condition.
Finally, Williams argued that ETE should be estopped from terminating the merger agreement because it represented at the time of signing that it did not know of the existence of any fact that would reasonably be expected to prevent the transaction from qualifying as a tax-free exchange under Section 721(a) of the Internal Revenue Code. The Supreme Court majority agreed with the Court of Chancery’s finding that ETE was not estopped from terminating the merger agreement because (1) ETE did not fail to disclose any facts known to it at the time of signing and (2) nothing in the record suggested that ETE knew of the “potentially problematic theory of tax liability” on the signing date and chose not to disclose it.
Based on the foregoing, the Supreme Court majority affirmed the judgment of the Court of Chancery.
Chief Justice Strine’s Dissent
In a 19-page dissent, Chief Justice Strine first faulted the Court of Chancery for focusing on the wrong issues. Rather than analyzing whether the Latham tax partner was being honest when he said he could not give the 721 Opinion, the Chief Justice believes the Court should have dug deeper into why the Latham tax partner was unwilling to give the opinion. Furthermore, when determining whether ETE used commercially reasonable efforts to obtain the 721 Opinion, the Chief Justice faulted the Court of Chancery for improperly focusing on whether ETE had somehow impeded Latham’s ability to provide the tax opinion, rather than on whether ETE took affirmative steps to ensure the 721 Opinion condition was satisfied.
The Chief Justice agreed with the Supreme Court majority that the Court of Chancery had misallocated the burden of proof. The Chief Justice proposed what he believed to be the proper lens through which to review the case: Where the merger agreement’s efforts covenants obligated ETE to take affirmative steps to ensure the 721 Opinion condition was satisfied, and ETE failed to take such steps, ETE must then prove that the 721 Opinion condition would not have been satisfied had it acted appropriately.
The Chief Justice acknowledged that the Court of Chancery, in a footnote, had indicated that the record was “barren of any indication” that ETE’s action or inaction materially contributed to Latham’s inability to issue the 721 Opinion, and that the result would be the same regardless of whether ETE’s actions were commercially reasonable and whether the Court had properly placed the burden of proof on ETE rather than Williams. This footnote, the Chief Justice commented, was not an appropriate substitute for proper analysis by the Court of Chancery.
The Chief Justice also criticized the Court of Chancery’s hasty acceptance of the Latham tax partner’s testimony that he could not get to the point where he could give the 721 Opinion, given that Latham was willing to give the opinion as of the signing date and up until the time it was contacted by ETE’s senior tax executive. Before such time, “Latham was preparing to issue the 721 Opinion and had never considered that it would be unable to issue it.” The Chief Justice also faulted the Court of Chancery for failing to confront the issue of the ETE’s senior tax executive’s motivations — i.e., the truthfulness of his “epiphany” and whether he raised the potential tax issue in an effort to influence the Latham tax partner not to give the 721 Opinion. Knowing that ETE was eager to avoid the merger, according to the Chief Justice, “it is difficult to imagine that he was not putting implicit, but undeniably extant, pressure on the Latham [tax partner] to have doubts about whether he could give the opinion.” ETE’s imposition of “undue professional pressure” on Latham “to get to no” would be in direct conflict with its duty to act in a commercially reasonable manner to obtain the 721 Opinion.
The Chief Justice highlighted several facts of record that could have led the Court of Chancery to conclude that ETE breached its obligations under the merger agreement. Specifically:
- ETE waited nine days — “a lifetime by deal standards” — to notify its M&A counsel about the potential tax issue. Not only did ETE fail to enlist its M&A counsel’s assistance with the analysis, but ETE also prevented its M&A counsel from collaborating with Latham to try to resolve it.
- Similarly, although ETE engaged secondary tax counsel to analyze and consult on the potential tax issue, ETE prevented its secondary tax counsel from speaking to either Latham or ETE’s M&A counsel about the issue.
- Latham waited two weeks before informing Williams’ M&A counsel that Latham was not able to provide the 721 Opinion, and only after Latham had already reached a firm conclusion on the point. The Chief Justice described that time gap as “commercially unreasonable and thus highly suspect.”
- Six days after notifying Williams’ M&A counsel, ETE filed an amended proxy statement publicly disclosing Latham’s position that it would not deliver the 721 Opinion, which the Chief Justice viewed as unnecessary and a tactic to lock Latham into its position.
- Upon learning of the issue, Williams’ M&A counsel proposed two possible solutions just two days later. Latham did not respond to the proposals for 15 days, more than a week after the amended proxy statement had been filed. Latham flatly replied that both proposals were unworkable, even though the testimony shows that certain lawyers at Latham and ETE’s secondary tax counsel thought one proposal had merit.
- Various lawyers and experts for both parties questioned the ETE’s senior tax executive’s theory that the Latham tax partner had adopted. Some believed there was no issue at all while others had their own reasons for fearing the second step of the transaction may not receive tax-free treatment.
The Chief Justice commented that ETE’s “suspicious” actions in combination (1) compromised the Latham tax partner’s ability to “find a way to yes” and (2) foreclosed meaningful consideration of proposed amendments to the transaction that might have resolved any genuine tax issue. For these reasons, the Chief Justice would have reversed and remanded the case for a new trial at which ETE would be required to prove that its breach did not materially contribute to the Latham tax partner’s failure to provide the 721 Opinion.
The Delaware Supreme Court’s opinion — and particularly Chief Justice Strine’s dissent — sheds light on how the Delaware Supreme Court will likely view the conduct of parties to M&A agreements and their counsel going forward. It may also incentivize members of the M&A and tax bar to draft merger agreement covenants and create tax opinion procedures in a manner that will not leave them vulnerable to the kind of scathing criticism leveled by the Chief Justice in his dissent.
The ruling may prompt merger parties to define “commercially reasonable efforts” and related terms in M&A agreements to circumvent judicial interpretation of those terms. Merger parties may also choose to explicitly agree to negotiate a resolution in good faith if a required tax opinion is not provided. Alternatively, the parties could require the tax opinion to be delivered at signing, and include a condition to closing that there have been no changes in the tax code or regulations between signing and closing that would impact the opinion that the transaction should qualify as tax-free. Finally, the parties may consider requiring that the tax opinion be provided by target’s — rather than buyer’s — tax counsel to enhance deal certainty.
1 The Williams Companies, Inc. v. Energy Transfer Equity, L.P., et al. (Del. Mar. 23, 2017), available here.
2 Hexion Specialty Chemicals, Inc. v. Huntsman Corp., 965 A.2d 715 (Del. 2008).
3 Williams did not challenge on appeal the Court of Chancery’s finding that Latham’s determination that it could not issue the 721 Opinion was made in good faith.
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