Private Equity: buyer's termination based on a breached capitalization representation

 

Introduction

In a recent opinion issued on May 29, 2023, the Delaware Chancery Court addressed a claim for specific performance under a merger agreement. The claim was brought by sellers against the buyer, following the buyer's termination based on a breached capitalization representation. The court concluded that the buyer was entitled to terminate the merger agreement, despite the buyer's acknowledgment that the value of the former employee's interest in the subsidiary was minor relative to the overall deal value.

 

Background and Decision

In December 2022, a merger agreement was entered into between affiliates of Antin Infrastructure Partners S.A.S ("buyer") and OpticalTel, a group of privately held broadband companies. The buyer was selected as the preferred bidder, even though it did not submit the highest bid, due to the perceived deal certainty it offered to the sellers.

 

Prior to signing the agreement, the buyer's counsel faced difficulties in fully verifying the capitalization table of OpticalTel. Consequently, the buyer negotiated several protective measures, including changing the deal structure to a merger to minimize the risk of post-closing claims from unknown equity holders. The sellers provided an uncapped indemnity for third-party claims related to breaches of the capitalization representation, and a closing condition required that all fundamental representations, including the capitalization representation, be true and correct at closing.

 

After signing the agreement, claims arose from two former employees of OpticalTel, including Rafael Marquez, who asserted an ownership interest in an OpticalTel subsidiary based on a 2004 Software Development Agreement. These claims led to concerns about potential capitalization issues. Despite considering other claims and counter-claims, the court's decision primarily revolved around Marquez's claim and its impact on the capitalization representation breach.

 

The court interpreted the 2004 Software Development Agreement and concluded that it granted Marquez a contingent right to payment upon a liquidation, constituting "phantom equity." Although the term "Equity Securities" did not explicitly cover phantom equity, the capitalization representation itself contained a representation from the sellers that there was no outstanding phantom equity. Thus, the court determined that the capitalization representation was not true and correct, allowing the buyer to terminate the merger agreement.

 

Sellers also argued that the buyer failed to use reasonable best efforts to consummate the merger, but the court disagreed, citing the buyer's extensive efforts to resolve the Marquez and other claims before termination.

 

Key Takeaways

 

Closing Certainty: The court's decision highlights the importance of carefully considering the standards applied to fundamental representations, such as capitalization representations, in acquisition agreements. While the outcome may have been different with a de minimis or materiality exception, the court ruled in favor of the buyer as the representation was brought down flat. Parties should weigh the impact of these standards on closing certainty when negotiating transaction terms.

 

Importance of Diligence: Although the Marquez and Iqbal claims emerged after signing, the buyer's diligence process had identified discrepancies in the capitalization of OpticalTel. This allowed the buyer to negotiate robust protections in the merger agreement, granting options to terminate or close the deal with indemnification. Thorough diligence can provide buyers with leverage to address specific identified issues and mitigate risks.

 

Buyer Compliance: Buyers must strictly comply with their obligations under the agreement until they have validly terminated it. A buyer looking to walk away from a transaction should ensure they fulfill their commitments, as failure to do so may result in a material breach and prevent termination.

 

Boilerplate Language: The court's opinion emphasizes the significance of well-defined boilerplate language in agreements. While the definition of "Equity Securities" in the merger agreement did not explicitly cover phantom equity, the inclusion of catch-all language in the capitalization representation provided the buyer with appropriate protections. Parties should consider comprehensive definitions and boilerplate language to address potential issues effectively.

 

Conclusion

The Delaware Chancery Court's recent opinion serves as a reminder of the importance of capitalization representations and the impact they have on merger agreements. It emphasizes the need for careful consideration of closing certainty, diligence processes, buyer compliance, and robust boilerplate language. By analyzing these key takeaways, parties to acquisition agreements can enhance their understanding of relevant legal points and strengthen their negotiating positions.