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Corporate Alert: Reasonableness of Merger Termination Fee Analyzed, Fiduciary Duty Not A Defense To Breach of Exclusivity Provision, Delaware Court Speaks to Judicial Dissolution of LLCs, Delaware Court Bars Creditors' Derivative Claims Against Insolvent LLC, Claims Barred on Behalf of a Corporation Against Outside Advisors in Corporate Frauds
Corporate Alert
November 2010
Authors: Edward B. Stevenson, Irwin A. Kishner

The Herrick Advantage

Herrick is the go-to law firm for players in the sports industry. Recently, we held a private movie screening of "Once in a Lifetime: The Extraordinary Story of the New York Cosmos." The event was well-attended by sports industry leaders and the feedback was overwhelmingly positive. Cosmos great Giorgio Chinaglia and new owner Paul Kemsley were on hand to take questions from those in attendance. We hope this will be the first in a series of sports movie screenings at Herrick, and we will let you know about these and other upcoming events. For more information on Herrick's Sports Group, click here.

Reasonableness of Merger Termination Fee Analyzed

The Delaware Court of Chancery has refused to enjoin a tender offer by 3M Company for the stock of Cogent, Inc., despite claims by Cogent's stockholders that its board of directors breached fiduciary duties owed to them by agreeing to preclusive deal protection measures and failing to pursue the best transaction reasonably available. 

In refusing the stockholder's claims, the court analyzed the actions taken by the Cogent board for reasonableness, with particular emphasis on the reasonableness of a termination fee contained in the transaction merger agreement. The termination fee, one of many deal-protection provisions in the merger agreement, was $28.3 million, representing 3% of the $943 million required to purchase the Cogent shares (the "equity value"). Plaintiffs claimed the cash on Cogent's books ($513 million) should reduce the equity value for purposes of determining the reasonableness of the termination fee and that the reduced value (the "enterprise value"), should instead be used. Based on the target's enterprise value ($430 million), the termination fee equaled 6.6%, which the plaintiffs challenged as being unreasonably high and a preclusive deal protection measure approved by Cogent's board of directors in breach of its fiduciary duties to its stockholders.

The court rejected the plaintiffs' claims, holding that Cogent's equity value, not its enterprise value, should be used in determining the reasonableness of the termination fee and that the 3% fee was within the range of reason. According to the court, the fact that Cogent had a significant amount of cash on its books did not change the fact that an acquirer must pay the full equity value in order to consummate the transaction. The court similarly held that the other deal-protection provisions in the merger agreement (including a no-shop, matching rights and so-called top-up option) were also reasonable and adopted by an informed board of directors. This case highlights the courts' unwillingness to enjoin transactions supported by a fully-informed and deliberative board of directors.

In re Cogent, Inc. S'holder Litig., Consol. C.A. No. 5780-VCP (Del. Ch. Oct. 5, 2010)

Fiduciary Duty Not A Defense To Breach of Exclusivity Provision

The Delaware Court of Chancery has held the seller in an asset purchase transaction liable for breach of an exclusivity provision in the subject asset purchase agreement, dismissing the seller's argument that the fiduciary duties owed by management to creditors negate the contractual exclusivity provision.

Millennium Digital Media Systems, L.L.C., a cable company, was in financial distress. After a series of unsuccessful refinancings, its creditors demanded that the company sell assets to repay its debt. Millennium entered into an asset purchase agreement with WaveDivision Holdings, LLC, a competing cable operator. The agreement contained a "no solicitation" provision, which required Millennium to deal exclusively with Wave and to refrain from engaging in any solicitation for, or encouraging, any alternative transactions involving the assets being sold. However, Millennium continued to actively pursue other alternatives, retaining a financial advisor to review potential investments and commencing negotiations for a refinancing with one of its senior creditors, Highland Capital Management. After almost six months of pursuing parallel tracks without informing Wave, Millennium terminated the Wave purchase agreement and that same day closed a refinancing deal with Highland. Wave sued for breach of contract.

Millennium argued that the no solicitation provision can't be enforced as a matter of law since complying with the provision would have forced Millennium's management to breach its fiduciary duties to its creditors. The court dismissed this argument outright as making no "economic or legal sense."  Though merger or asset purchase agreements that involve sale of control of a target company may contain a "fiduciary out" provision, the court stated that companies are "free to enter into binding contracts without such a fiduciary out so long as there was no breach of fiduciary duty involved when entering into the contract in the first place." Under Delaware law, if a contract with a third party is premised upon breach of fiduciary duty, a court may find it to be unenforceable on equitable grounds.

WaveDivision v. Millennium, C.A. No. 2993-VCS (Del. Ch. September 17, 2010)

Delaware Court Speaks to Judicial Dissolution of LLCs

The Delaware Court of Chancery has granted the plaintiffs' request for judicial dissolution of BVWebTies LLC, a Delaware limited liability company. In the case, co-equal owners and managers of the LLC disagreed over the company's management.  The company's LLC agreement, however, provided no method by which to break a deadlock among the members. The plaintiffs, citing the inability to break the deadlock, sought for the dissolution of the company, while defendants, citing the company's profitability, argued that the business should be allowed to continue and that its existence was reasonably practicable. The court agreed with the plaintiffs, finding that it was not reasonably practicable for the company to operate in conformity with the LLC Agreement and that judicial dissolution was warranted. In cases involving co-equal owners or co-equal managers, one co-equal manager cannot simply lock out the other or operate the business without the consent of the other, but if an attempt is made, it is a persuasive basis for dissolution. The opinion adds depth to the case law surrounding Section 18-802 of the Delaware LLC Act, which allows members of an LLC to seek dissolution when it is not reasonably practicable to continue to operate an LLC.

Vila v. BVWebTies LLC, C.A. No. 4308-VCS (Del. Ch. Oct. 1, 2010)

Delaware Court Bars Creditors' Derivative Claims Against Insolvent LLC

The Delaware Court of Chancery has held that under the Delaware Limited Liability Company Act, creditors of an insolvent Delaware limited liability company do not have standing to pursue a derivative claim against the managers of the company.

CML V, LLC lent money to JetDirect Aviation Holdings LLC, a private jet charter service, which was later determined to be insolvent. Following JetDirect's insolvency and its subsequent default on CML's loan, CML asserted derivative claims against the JetDirect's managers, arguing that they had breached their fiduciary duties to JetDirect by approving a number of imprudent acquisitions that lead to JetDirect's insolvency.

In denying CML standing to pursue a derivative claim against the managers of JetDirect, the court reasoned that the Delaware LLC Act limits such standing to holders of membership interests in an LLC and their assignees, and does not statutorily afford such standing to a company's creditors. In comparison, the Delaware General Corporation Law does not limit standing in a derivative suit against a corporation to stockholders only. The court justified its reading by noting the "contractarian spirit" at the heart of the Delaware LLC Act.

CML V, LLC v. Bax, C.A. No. 5373-VCL (Del. Ch. Nov. 3, 2010)

Claims Barred on Behalf of a Corporation Against Outside Advisors in Corporate Frauds

The New York Court of Appeals has reaffirmed that the doctrine of in pari delicto bars lawsuits against a corporation's outside advisors in connection with a corporation's fraudulent activities. New York's highest court, answering certified questions from the United States Court of Appeals for the Second Circuit and the Supreme Court of Delaware, declined to adopt the approach taken by the highest courts in New Jersey and Pennsylvania, which have permitted recovery against outside advisors in light of recent financial fraud scandals.

The doctrine of in pari delicto is often asserted as an affirmative defense by outside advisors against claims that they acted negligently or colluded with management in fraudulent activities.  Pursuant to this doctrine, a court will not intervene in disputes between two wrongdoers (e.g. in an action between a corporation, whose officers are accused of fraud, and that corporation's outside auditors, who allegedly assisted in the fraud).  The court acknowledged the general presumption of agency law that the acts of agents, while acting in the scope of their authority, are imputed to their principals. Thus, bad acts by corporate agents are imputed to the corporation itself. Although New York recognizes a limited exception to this general presumption in the event that an agent acts adversely to its principal, the court explained that the exception is very narrow and will only be applied in the event that an agent has acted with "total abandonment" of the corporation's interests and has engaged in misconduct benefitting only the agent and not the corporation. In highlighting New York's limited exception to the imputation presumption, it refused to adopt the carve-outs used in New Jersey and Pennsylvania, which permit claims against negligent or colluding outside advisors based on equitable principals.

As a result, New York law will continue, other than in narrow circumstances, to bar claims against outside advisors, such as auditors and lawyers, for failing to detect, or for assisting management with, fraudulent activities.

2010 N.Y. Slip Op. 7415 (N.Y. Oct. 21, 2010)

For more information on these issues or other corporate matters, please contact:
NY     Irwin Kishner at 212.592.1435 or ikishner@herrick.com
NJ     Edward Stevenson at 973.274.2025 or estevenson@herrick.com

Copyright © 2010 Herrick, Feinstein LLP. Corporate Alert is published by Herrick, Feinstein LLP for information purposes only. Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm.