Delaware Supreme Court Upholds Decision Permitting Energy Transfer To Exit Williams Merger
The Delaware Supreme Court recently affirmed a lower court’s decision allowing Energy Transfer Equity to abandon a planned merger with Williams Cos. based on ETE’s failure to obtain a tax opinion from outside counsel, which was a contractual condition to closing. The decision sheds light on how Delaware courts will view parties’ obligation in an M&A agreement to use "reasonable best efforts" or "commercially reasonable efforts.”
Initially valued at more than $30 billion, Energy Transfer Equity’s planned merger with rival pipeline operator Williams was one of the largest M&A deals of 2015. One critical element was that the acquisition of the Williams assets would be tax-free. Closing of the deal was conditioned upon ETE’s outside tax counsel issuing an opinion under Section 721(a) of the Internal Revenue Code stating that the transaction “should” be treated by the tax authorities as a tax-free exchange.
Following the September 2015 execution of the deal the energy markets declined, threatening ETE’s ability to finance the $6 billion cash portion of the merger. During the pre-closing period, ETE’s tax director raised concerns that the IRS might not in fact view the transaction as tax-free. These concerns were communicated to ETE’s outside counsel, which decided it could no longer deliver the 721 opinion.
Williams filed a lawsuit arguing that ETE was using the tax issue to back out of the deal due to buyer’s remorse. But in June 2016, the Chancery Court held that ETE’s outside counsel had not acted in bad faith by failing to issue the 721 opinion and that ETE did not breach its obligation to use "commercially reasonable efforts" to obtain such opinion. Williams subsequently appealed to the Delaware Supreme Court.
In a 4-1 decision, the Delaware Supreme Court said the Chancery Court took an unduly narrow view of the obligations imposed on ETE by the merger agreement. It said the lower court should have looked at whether ETE had taken all reasonable steps to obtain the tax opinion from outside counsel, rather than focusing on the lack of evidence showing ETE caused counsel to withhold the opinion. The court also agreed with Williams that once a breach of covenant is established, the burden shifts to the breaching party to show that the breach did not materially contribute to the failure of the transaction.
The Delaware Supreme Court’s decision to affirm turned on a finding that the record was “barren of any indication” that ETE’s action or inaction contributed materially to its outside counsel's inability to issue the 721 opinion. In a 19-page dissent, Chief Justice Leo Strine said he would remand the case back to the Chancery Court for a new trial.
The Delaware Supreme Court’s decision clarifies that parties in an M&A agreement need to take all reasonable steps to correct issues that might arise and complete the transaction. Failure to do so could result in a finding that one side breached its covenants.
A practical takeaway is that parties to a merger might be more inclined to define the meaning of “commercially reasonable efforts” and similar terms in the agreement in order to avoid interpretation by a court. One might also consider requiring that the 721 opinion be provided by the target company’s lawyers to increase deal certainty.