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Recent Delaware Chancery Court Decisions Opines on Arbitration Clause in Merger Agreement

Posted on Oct 1st, 2013

A recent letter opinion by the Delaware Chancery Court in a case between Shareholder Representative Services (SRS) and a buyer of a business processing business raises an interesting interpretation of an arbitration clause in a merger agreement. The case can be read here.  The dispute between the parties arose from indemnification claims brought by the buyer under the merger agreement, which SRS claimed did not comply with the requirements of the merger agreement.  While the merger agreement contained a mandatory arbitration provision, it also provided that the Arbitrator did not have authority to grant “injunctive relief, specific performance or other equitable relief”.  Relying on this provision, SRS brought various claims in the Chancery Court, including a claim for injunctive relief to stop buyer from a breach of the merger agreement by seeking indemnification to which it did not have a right.  The court disagreed with SRS and compelled arbitration.

The court first noted that since the arbitration clause did not explicitly commit the determination of substantive arbitrability to the arbitrator, the court had jurisdiction to decide on this specific issue.  In a footnote, the court noted that these issues are presumptively determined by a court.  (One drafting note from this determination is that parties that wish to avoid any court proceedings altogether may want expressly cover the issue of substantive arbitrability in their agreement.)

The court cited a 2002 Delaware Supreme Court decision for the steps to be taken by a Delaware court to assess an arbitration clause:

  • First, the court must determine whether the arbitration clause is broad or narrow in scope.
  • Second, the court must apply the relevant scope of the provision to the asserted legal claim to determine whether the claim falls within the scope of the contractual provisions that require arbitration. If the court is evaluating a narrow arbitration clause, it will ask if the cause of action pursued in court directly relates to a right in the contract. If the arbitration clause is broad in scope, the court will defer to arbitration on any issues that touch on contract rights or  contract performance.

The court cited a few examples of a “broad” arbitration clause:  “any dispute, controversy, or claim arising out of or in connection with the …Agreement” and “any unresolved controversy or claim arising out of or relating to this Agreement” (the language at issue in the parties’ merger agreement). Finding this clause to be of the broad category, the court ruled that the determination of whether the indemnification claims were time-barred should be made by the arbitrator.

In support of its argument, SRS cited a 2006 decision involving an arbitration clause in a LLC operating agreement where the parties also sought injunctive relief from the court to compel a member to assent to a capital contribution.  The court distinguished this situation from the instance case, finding that SRS’s claims were really legal claims, not equitable ones, and colorfully noted that “[s]emantic legerdemain does not transform a legal claim into an equitable claim.”  The court reasoned that the relief that SRS has requested requires an analysis of the merits of the claims, which is legal (as opposed to equitable) in nature.   Accordingly, a plaintiff cannot “convert a claim for money damages arising from a breach of commercial contract . . . into a claim maintainable in equity by the expedient of asking that the defendant be enjoined from breaching such duty again.”

This decision is a useful reminder that boilerplate provisions such as arbitration clauses (and carveouts to those clauses) should be carefully considered in the context of any agreement, especially one relating to the sale of a business or other major transaction of a company.  While there may be varying opinions on the benefits of arbitration over litigation, once a path is chosen, the parties should carefully review these provisions to reduce ambiguity around any substantive and procedural issues that may arise.

If you have any questions about this topic, please feel free to email us.


Who’s Up for Tax-Free Capital Gains?

Posted on May 11th, 2013

From the editor:  We saw many companies raising capital in 2010 and 2011 to take advantage of the tax relief under Section 1202 of the Internal Revenue Code to give investors the potential for tax-free gains if they held the stock for the required 5 years and the company met certain conditions.  While that relief went away in 2012, recent tax law enactments have brought back this tax treatment for 2012 and 2013. We would like to thank our tax colleague Travis Blais from Travis Blais & Co.  for preparing the following post on this topic:

Most of us know that the American Taxpayer Relief Act of 2012, better known as the “fiscal cliff bill,” extended lower across-the-board tax rates, including those for dividends and long-term capital gain, for all but a handful of taxpayers.  Less well known is that the ATRA extended many business tax benefits, including the possibility of tax-free capital gains for “qualified small business stock” (QSBS).

Tax-free?  Yes.  QSBS is potentially the ultimate tax bargain – QSBS acquired through the end of 2013 and held for 5 years will incur 0% capital gains tax upon eventual sale. Of note, QSBS was extended retroactively, meaning stock previously acquired in 2012 as well that acquired in 2013 may qualify.

As you would expect, this kind of benefit comes with a lot of conditions.  The stock must be of a domestic C corporation, purchased at original issue for money, property other than stock, or services.  As a shareholder, a C corporation itself is not eligible for the tax-free treatment.  The tax-free gain is limited to the greater of “10x” (10 times one’s investment) or $10 million.  To be a “qualified small business,” the issuing corporation must never have had assets greater than $50 million either before or immediately after the stock purchase.  Moreover, 80% of the corporation’s assets must be used in a qualified trade or business, which excludes professional services, finance, farming, mining, or hospitality.For many investors, the most daunting requirement is that stock must be held for at least five years to qualify for the 0% rate.  In this regard, it is helpful that QSBS can be “rolled over,” that is, sold and its proceeds used to purchase different QSBS, deferring capital gains recognition and “tacking” the holding periods in hopes of crossing the five-year finish line.The obvious opportunity to acquire QSBS is upon the startup of a new business or a venture capital investment in an existing, small corporation.  But be on the lookout for less evident QSBS situations.  For instance, LLCs could be converted to corporations, particularly in anticipation of an investor financing that might require such a conversion anyway.  Investors might be holding stock rights in the form of options or convertible debt that could be exercised into stock.  Or QSBS may be available in newly formed shell corporations created to pursue a reverse acquisition.

Travis Blais