In an expedited deal litigation matter, in The Williams Companies, Inc. v. Energy Transfer Equity, L.P., C.A. No. 12168-VCG (Del. Ch. June 24, 2016), the Court of Chancery denied a request to enjoin Energy Transfer Equity, L.P. (“ETE”) from evading a deal based on its inability to obtain a tax opinion that was a condition precedent to closing on a deal with The Williams Companies, Inc. Although the facts of this case are somewhat sui generis, the legal principles addressed should have broader application, not only for deal litigation but contract litigation in general.

The court’s discussion of the concept of “commercially reasonably efforts” and “reasonable best efforts” is useful to remember. The court distinguished the two prior Chancery opinions in Hexion, highlighted on these pages previously, and WaveDivision Holdings, highlighted on these pages, in part because, on a factual level, in both of those cases the Court of Chancery found, unlike in the instant case, that a party took affirmative steps, in violation of the relevant cooperation clause, to thwart a condition to closing such as using commercially reasonable efforts, or reasonable best efforts, to obtain financing or to obtain the consent of a third party to the deal.

Short Overview of the Basic Facts

After the merger agreement between the parties was entered into, the energy market, and the value of the assets in the transaction, experienced a precipitous decline. Since a part of the consideration for Williams was $6 billion in cash, which ETE would have to borrow against its devalued assets to obtain, the proposed transaction quickly because financially unattractive to ETE as the buyer. Thus, ETE was looking for an exit from the merger agreement, although initially it had been an ardent suitor of The Williams Companies.

One of the key facts of the case was that a condition precedent to consummation of the merger was the issuance of an opinion by the tax attorneys for ETE at the law firm of Latham & Watkins. The firm was specified in the agreement, and in its sole discretion, was to issue an opinion as a prerequisite to closing, to the effect that the transaction “should” be treated as a tax free exchange under Section 721(a) of the Internal Revenue Code. Although Latham initially, at the time the agreement was signed, expected to be able to issue that opinion, after the agreement was signed something changed. Based on the effect of changing market conditions and reduced value of the stock on the tax impact, Latham disclosed that it was no longer able to issue such an opinion. One of the claims that Williams maintained against ETE was that it failed to use “commercially reasonable efforts” to secure the Latham opinion and, therefore, materially breached its contractual obligations.

The court approached the inability of ETE to obtain the Latham opinion with skepticism, amid claims that it was a ruse to allow it to back out of the deal in light of the downturn in the energy market which made the deal financially problematic. Another important fact is that the court found that the person at ETE in charge of tax issues did not accurately read or understand the terms of the deal at the time the agreement was signed, and both he and the Latham firm only realized there was a problem in issuing a the tax opinion after the agreement had been signed. Curiously there were six different tax opinions presented at trial by independent experts and tax experts connected with the deal. Some of those opinions were contradictory.

Money Quote

Notwithstanding the court’s initial skepticism and the motive that ETE had to avoid the closing, a few money quotes from the court have application far beyond this case. For example, the court reasoned that:

“Just as motive alone cannot establish criminal guilt, however, motive to avoid a deal does not demonstrate lack of a contractual right to do so. If a man formerly desperate for cash and without prospects is suddenly flush, that may arouse our suspicions. Nonetheless, even a desperate man can be an honest winner of the lottery.”

Court’s Holding

The court explained in its 58-page post-trial opinion, issued the same week that the trial ended, that Delaware is a contractarian state, and recognizes and respects provisions in contracts that favor specific performance in case of breach. But conditions precedent to a transaction must be enforced as well. The request of Williams to force the court to consummate the deal with ETE would force ETE to accept the risk of substantial tax liability which the parties did not contract for.

Key Issues

Among the key issues the court had to consider was whether the Latham firm determined “in good faith” that it was unable to issue the tax opinion. Williams argued that Latham reached a conclusion that it could not issue the opinion in bad faith and for reasons other than its best legal judgment, in order to please its client. That relates to the argument that ETE persuaded Latham not to issue the necessary opinion, which, if true, would be a breach by ETE of the requirement that it use commercially reasonable efforts to obtain the opinion.

The court articulated the issue as whether Latham determined in “subjective good-faith” that it could issue the necessary opinion which was a condition precedent to closing. The court observed that Latham was a law firm of “national and international repute” and that is was at the very least a blow to the reputation of the firm and its tax partners that they had preliminarily advised that the deal would qualify for certain tax treatment, but had to backtrack in a way that “caused the ‘deal to come a cropper.’”

Among the six different tax experts who testified at trial about the ability to issue the necessary tax opinion that was a condition precedent, one tax law professor testified that “no reasonable tax attorney could agree with Latham’s conclusion,” but another professor testified that the conclusion of Latham that it could not issue the opinion was appropriate. Other law firms argued that although the conclusion of Latham was correct, the reasoning for that conclusion was different.

In its analysis of subjective good-faith, the court observed that it was a “substantial embarrassment to Latham” that it was not able to issue the opinion despite its initial view that it could do so, and that the reputational effects outweighed any benefit of an unethical deference to the interests of its client because “while this deal is, certainly, a lunker, Latham has even bigger fish to fry.” The court also noted a blog post from one of the Wall Street Journal’s blogs that Latham & Watkins had been a clear loser on the deal regardless of who won the litigation. See footnote 122.

Legal Principles Discussed

The court observed that the phrase “commercially reasonable efforts” was not defined in the agreement, and that even though the phrase has been addressed in other cases – – “the term is not addressed with particular coherence in our case law”. The phrase has also been articulated as “reasonable best efforts” which has been described as “good-faith in the context of the contract at issue.” Citing Hexion Specialty Chemicals Inc. v. Huntsman Corp., 965 A.2d 715 (Del. 2008), the court found that the phrase “commercially reasonably efforts” in the agreement in this case required the purchaser, ETE, to submit itself to a “objective standard to ‘do those things objectively reasonable to produce the desired’ tax opinion in the context of the agreement reached by the parties.”

The court found that the argument by Williams regarding burden of proof was wrong, and that the buyer, ETE, did not have the burden to “prove a negative.” That is, it did not need to show that its lack of more forceful action, or that a specific action taken, was the reason that Latham did not render a tax opinion. The court similarly distinguished the holding in WaveDivision Holdings, LLC v. Millennium Digital Media Sys., LLC, 2010 WL 3706624 (Del. Ch. Sept. 17, 2010). See footnote 130.

Regarding the court’s reasoning about why ETE did comply with its obligation to use commercially reasonable efforts, the court explained why the arguments of Williams were rejected. Williams argued that ETE:

“. . . generally did not act like an enthusiastic partner in pursuit of consummation of the Proposed Transaction. True. The missing piece of Williams’ syllogism is any demonstration that the Partnership’s activity or lack thereof, caused, or had a materially effect upon, Latham’s current inability to issue the [tax opinion].”

Thus, one may read the above quote as suggesting that “not being enthusiastic about closing a deal” is insufficient to breach a duty to use commercially reasonable efforts. The missing part of Williams’s syllogism described by the court is a key fact that distinguished both the Hexion case and the WaveDivision case because the non-performance allegation and the lack of best efforts allegation – – even if true – – did not contribute materially to the failure of the goal to which the “efforts clause” was directed. See footnotes 122 and 123 and accompanying text.

Postscript: Courtesy of The Chancery Daily, we understand that this decision has been appealed to the Delaware Supreme Court. The Court of Chancery facilitated this option by noting in an Order that accompanied the opinion that pursuant to Rule 54(b), this ruling was appealable although it did not conclude all issues at the trial court level.

Supplement: The venerable Professor Bainbridge provides professorial commentary on the use of the phrase “commercially reasonable efforts” and variants, and observes how common it is to use this phrase, and its variations, without definition and without precision. We are also grateful that the good professor links to yours truly and this post in his discussion.

Second Supplement: In a more recent transcript ruling, in a separate case, another vice chancellor addressed the standard of “commercially reasonable efforts” in the context of a motion to dismiss, as opposed to the post-trial findings in the Williams case. In the matter styled:WP CMI Representative LLC v. Roche Diagnostics Operations Inc.,  C.A. No. 11877-VCL (transcript)(Del. Ch. July 14, 2016), the money quote is found at page 56 of the above-linked transcript ruling when the court explains that a reasonable inference that the parties’ interests are aligned can be defeated when the party with the duty to act in a commercially reasonable manner, does “… something that wasn’t originally contemplated and which has the effect of causing the milestone not to be hit….” In that context, it might be “reasonably conceivable” [under Rule 12(b)(6)] that the change in behavior that was  not originally contemplated or not consistent with past practice, may be a change that was not commercially reasonable.

This post was prepared by an associate in the Delaware office of Eckert Seamans.

Why this ruling is notable: The Court of Chancery advised the parties in the context of a Motion to Compel (MTC), after discovery had closed, that the parties should agree on search terms for e-discovery at the beginning of the discovery process. Archer VI, LLLP v. Archer on North, LLC et al. v. Archer Properties, C.A. No. 11237-CB, hearing(Transcript)(Del. Ch. May 2, 2016).

Background: Discovery was complete in this case at the time of the oral argument on the MTC, and dispositive motions were due approximately two weeks later. Search protocols for e-discovery were never exchanged between the parties. In their MTC, the defendants sought communications between the Plaintiff (Archer VI) and the third-party defendant (Archer Properties).

Following the defendants’ filing of the MTC, the plaintiffs made three productions. Those productions satisfied most of the issues briefed in the MTC. However, the defendants were still seeking other communications

The Court Provides Advice on the Timing of and Search Terms for e-discovery: First, the court observed the timing of this motion was later than ideal. It was filed after the close of discovery and after depositions had been taken. The court also reminded the parties of their obligation to meet and confer on discovery disputes before bringing them to the court’s attention. The court ordered all communications between the defendants’ principals be produced with no subject matter limitation on either search.

Search Terms: Then, the parties were ordered to develop search terms for internal communications for the management of the property and it was suggested that this should have been done at the outset of the case. The court also declined to take an in-camera review of the missing pages—which had been redacted because of a claim of privilege. Defendants were advised to file a motion if they felt strongly about such a review, if a “meet and confer” was not fruitful.

The court also declined to impose sanctions on the plaintiffs because it observed both sides were partially at fault for the discovery deficiencies.

Finally, pointing out the small amount in controversy ($35,000) and the fact that much more than that amount was likely spent on this discovery issue alone, the parties were ordered to seek leave of the court if they wish to file a motion for summary judgment.

Why this Case is Noteworthy: The Court of Chancery’s opinion in Laborers’ District Council Construction Industry Pension Fund v. Bensoussan, C.A. No. 1123-CB (Del. Ch. June 14, 2016), is the second decision from the Court of Chancery in two months that provides a reasonable basis for skepticism about whether, as a practical matter, plaintiffs’ attorneys should wait for the results of a Section 220 action before filing a plenary derivative suit. This case involves the popular Lululemon brand of athletic apparel, and allegations of insider trading at the company.

Overview: This opinion needs to be viewed in the context of a Chancery opinion issued last month styled In Re Wal-Mart Stores, Inc. Delaware Derivative Litigation, in which the court found that Delaware derivative litigation was barred due to a prior dismissal in another state of a derivative suit that was filed involving similar claims. The plaintiffs in that related litigation in another state, that was dismissed with prejudice, did not use Section 220. In the Wal-Mart case, as in the instant case, the Delaware plaintiffs waited until their Section 220 claims were litigated before filing their plenary action. By that time however, the litigation that was filed earlier in another jurisdiction, and which was not delayed by Section 220 demands, was dismissed. The Court of Chancery in this case found that the additional information that was obtained through the Section 220 action was not a sufficient reason to avoid the principles of issue preclusion, and claim preclusion, that prohibited the Delaware case from proceeding.

Readers should closely review the 40-page decision, but among several highlights include the following:

Procedural Background:

This litigation was preceded by two separate Section 220 actions. In one of those actions, after trial, the court largely rejected the request for books and records under Section 220. In the other Section 220 action that preceded this litigation, the court ordered the production of some documents but still a motion to compel was required because of a dispute about attorney/client privilege. That dispute resulted in a written opinion that was highlighted on these pages here. See In Re Lululemon Athletica Inc. 220 Litigation, Cons. C.A. No. 9039-VCP (Del. Ch. Apr. 30, 2015).

That decision on Section 220 issues was rendered approximately two years after the first Section 220 litigation was filed in Delaware as a prelude to the instant decision in the plenary case. My comments at the above link regarding the Section 220 opinion, and the shortcomings of Section 220 in general, apply here as well.

Key Takeaway:

The court found that simply because the plaintiffs and their counsel in the New York litigation did not first file a 220 action, or wait for a 220 action to conclude, that fact alone did not, ipso facto, make the plaintiffs in that derivative case inadequate representatives for that litigation. See page 32 and footnote 69 – 70 and accompanying text. See also footnote 75 referring to the Delaware Supreme Court opinion in Pyott, highlighted on these pages, which held that not using Section 220 prior to a derivative action does not create an irrebuttable presumption of inadequacy of representation.

Why This Case is Important: The Court of Chancery opinion in Obeid v. Hogan, C.A. No. 11900-VCL (Del. Ch. June 10, 2016), will be cited often as a reference guide for fundamental principles of Delaware corporate law and LLC law, including the following: (1) even in derivative litigation when a stockholder has survived a motion to dismiss under Rule 23.1, for example, in which demand futility is an issue, pursuant to DGCL Section 141, the board still retains authority over the “litigation assets” of the corporation, and if truly independent board members exist, or can be appointed, to create a special litigation committee (SLC), it is still possible for the SLC, under certain circumstances, to seek to have the litigation dismissed; (2) if an LLC Operating Agreement adopts a form of management and governance that mirrors the corporate form, one should expect the court to use the cases and reasoning that apply in the corporate context; (3) even though most readers will be familiar with the cliché that LLCs are creatures of contract, the Court of Chancery underscores the truism that it may still apply equitable principles to LLC disputes; (4) a bedrock principle that always applies to corporate actions is that they will be “twice-tested,” based not only on compliance with the law, such as a statute, but also based on equitable principles.

The facts of this case are recited in a comprehensive manner in the court’s opinion, along with scholarly analysis, but for purposes of this short blog post, I will provide bullet points.

Key Points:

• This opinion provides a roadmap for how a board should appoint a special litigation committee with full authority to seek dismissal of a derivative action against a corporation. See pages 30 to 32.
• The LLC agreement in this case imported the language of Section 141(c) of the Delaware General Corporation Law regarding the composition of a special litigation committee of the board. This LLC agreement adopted a form of governance that mirrored the management of a corporation and included a board of directors. Therefore, the court applied a corporate law analysis, see footnote 5, including an exemplary explanation of the seminal Delaware Supreme Court decision in Zapata that articulated the controlling corporate law principles in connection with special litigation committees. See page 16.
• The Zapata case was applied to explain that even if a majority of the board is disqualified by lack of independence, it can still delegate its power to a disinterested committee with full board power to decide to move to dismiss a derivative suit filed against the corporation. This may require that additional members of the board be appointed, if possible, who are truly independent. See pages 22 and 23.
• The court explained that the SLC has the burden to demonstrate its independence and good faith and that it conducted a reasonable investigation. Moreover, the court has discretion to make its own judgment regarding the soundness of the decision of the SLC. See pages 24 and 25. This opinion provides an excellent explanation of the concept of the SLC.
• This may be somewhat controversial in some circles, but the court explained its reasoning for why it still has the power and authority to apply equitable principles to LLC disputes. See page 11 at footnote 2. See also a recent article on this topic by Prof. Mohsen Manesh, entitled “Equity in LLC Law“, which addresses this concept and includes a discussion of another recent Chancery decision, In Re Carlisle, Etc.,  announcing the same principle.
• The foregoing reminder of the court’s equitable powers is related to a bedrock principle that all corporate acts are “twice tested,” based on compliance with both the law and equity. See footnote 12 and accompanying text.

In closing, we are happy to note that the scholarship of a very good friend of this blog, and nationally recognized corporate law scholar, Professor Stephen Bainbridge, was cited in this court opinion at footnote 16. It is not uncommon for Professor Bainbridge’s scholarship on corporate law issues to be cited by the Delaware courts, but it is still worth noting. [In addition to this case, the good professor was also cited in another Chancery decision recently, in the matter styled: Pell v. Kill, No. 12251-VCL, 2016 WL 2986496, at *16 (Del. Ch. May 19, 2016).]

Supplement: Professor Bainbridge provides erudite commentary on this case, and he kindly quotes this post. He also provides excerpts of client memos on this case from the Richards Layton and Morris Nichols firms.