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Massachusetts Appeals Court Rejects Stockholder Representative’s Appeal to Deny Partial Settlement Out of Escrow Fund

Posted on Dec 4th, 2013

A recent decision by the Massachusetts Appeals Court interprets the right of a seller shareholder to bypass a stockholders’ representative and settle directly with a buyer claimant and to use for such settlement the proceeds from an escrow fund established as part of the sale transaction.  This opinion is an important read for anyone engaged as a stockholders representative or serves as counsel to one.   While the decision is somewhat limited by the specific provisions of the merger and escrow agreements at issue, corporate practitioners may find the facts useful for tightening up standard provisions on these issues in future deals.  The case also provides a handy explanation of the oft-used (and misunderstood) term “power coupled with an interest”, which we have summarized below.  A full copy of the opinion can be found here.

The case arises from a stock purchase merger in September 2007 of Atlantis Components, Inc. by Astra Tech, Inc.  for $71 million. Per common practice, $6.3 million of the purchase price was placed into an escrow fund, to be disbursed to the former Atlantis shareholders on a pro rata basis on December 31, 2008, the release date. The purpose of the the escrow fund was to indemnify Astra Tech if it paid any claims asserted against Atlantis after the closing date but before the release date. The merger agreement designated a Shareholder Representative as the agent of the former Atlantis shareholders, which had the duty of approving or challenging any indemnification claim on the escrow fund.

Shortly after the closing, Astra Tech brought a claim against Atlantis for failing to disclose  certain correspondence alleging that Atlantis was infringing on the patents of one its competitors.   The parties disagreed on the merits of AstraTech’s claims and various lawsuits ensued.  As legal costs for these matters ballooned to nearly $2.5 million, in October 2010 certain of the Atlantis shareholders opted to settle directly with Astra Tech, using their pro rata share of the escrow fund as payment.  After reaching an agreement, the settling shareholders and Astra Tech moved in Superior Court for approval of their settlement. The shareholders’ agent opposed the settlement, on the basis that neither the merger agreement nor the escrow agreement permitted the settling shareholders to seek disbursement absent the consent of the shareholders’ agent. A judge approved the settlement agreement between Astra Tech and the settling shareholders and this appeal followed.

The Court’s decision involved the interpretation  and interplay of three contracts between the parties: (1) the escrow agreement between Astra Tech, Atlantis, the stockholders rep, and the escrow agent; (2) the merger agreement between Astra Tech, Atlantis, and the stockholders rep; and (3) the settlement agreement between Astra Tech and the settling shareholders.

On the escrow agreement, the Court determined that that the express provisions of that Agreement did provide for a procedural mechanism to allow the settling shareholders to seek court approval of their settlement.  An excerpt of that provision is provided below for reference. (1)

On the merger agreement, the stockholders rep argued that it had the exclusive right to negotiate with Astra Tech under under Sections 8.6(a) and (e) (pasted as footnote (2) below).  While the Court agreed that these provisions granted the Stockholders Rep with broad powers to negotiate and make decisions for the settling shareholders, it held that these rights were not exclusive, which would be required to bar the settling shareholders from negotiating for themselves.  The Court refused to construe the provision that the rep’s decisions and acts “constitute a decision of all Company shareholders” and are “final, binding and conclusive upon each such Company Shareholder” as granting the rep with exclusive rights.   To create an exclusive agency, the parties must expressly and unambiguously indicate such an intent in the contract.”  The Court noted that if the parties had wished to give the shareholders’ agent the sole or exclusive authority to negotiate on behalf of the settling shareholders, they should have provided for that expressly in the contract. (“We will not contort the plain language of the merger agreement to interpret “final, binding and conclusive” as synonymous with “irrevocable” or “exclusive.”)

Finally, the stockholders rep contended that its agency was irrevocable because it has a “power coupled with an interest.”  The Court disagreed.   Despite general agency law principles (which allow a creator of the agency relationship to revoke the agent’s authority at any time, even if their agreement expressly states that the principal may not revoke), the agent’s authority can be made irrevocable when it is a “power coupled with an interest”.  The Court explained that a ”power coupled with an interest is not technically an agency relationship because “it is neither given for, nor exercised for, the benefit of the person who creates it.”  In an agency relationship, granting authority to the agent is solely for the benefit of the principal, but when a “power is coupled with an interest, the donee holds that power for his own benefit (or for the benefit of a third party), but not for the benefit of the donor.”  The reference to “interest” in this phrase means that the agent (donee of the power) must have a present interest in the property upon which the power is to operate.  It is generally accepted that the “interest” must be ownership of the property itself and it is this ownership which makes the power irrevocable.

In its analysis, the Court broke down the term “a power coupled with an interest”  into two components: first, does the agent have “a power”, and second, is the power “coupled with an interest.  On the first point, the Court held that the  rep did not have “a power” in the escrow fund, as it did not have  exclusive or irrevocable power under the merger agreement or the escrow agreement.  The rep also did not have unilateral power in the escrow fund (a distinguishing factor in other cases cited by the Court) but rather was required to reach an agreement with Astra Tech before the escrow agent could be compelled to release the funds.

On the second point, the stockholders rep did not have “an interest” in the escrow fund sufficient to create a power coupled with an interest.  Citing cases going back to 1823, the common thread requires the agent to have title or some other form of ownership of the underlying asset to assert that the power is “coupled with an interest”.   Even though the shareholders rep (as a Atlantis shareholder) had a personal interest in a portion of the escrow, it did not have a property interest in the entire fund in its capacity as shareholders’ agent.  The Court emphasized that the critical distinction between an agent and the donee of a power coupled with an interest lies in who receives the benefit of the relationship. “In a principal-agent relationship, the principal receives the benefit; for a power coupled with an interest, the benefit inures to the donee himself (or to a third party), but not to the donor.”

After concluding that the stockholders rep had neither the exclusive right to negotiate under the merger agreement nor a power coupled with an interest in the entire escrow fund, it then held that the settling shareholders did have a right to bypass the rep and enter into a direct settlement with Astra Tech.  In the absence of an agreement, the settling shareholders retain their common-law rights as principals. Notwithstanding any agreement between principal and agent, an agent’s actual authority terminates … if the principal revokes the agent’s actual authority by a manifestation to the agent. Because a principal may revoke part of the agent’s authority, it follows that a principal may, in the absence of an agreement to the contrary, negotiate on his own behalf without infringing on the agent’s ability to perform his duties.  Because nothing in the agreements abrogated these common-law rights, the Court held that the settling shareholders had the power to negotiate a settlement agreement with Astra Tech.

This opinion illustrates a number of interesting drafting points for preparing escrow and stockholder rep provisions in complex merger and sale agreements.  At the very least, practitioner may wish to counsel their clients on the alternatives of exclusive and nonexclusive roles of the rep and the possible ways those results can be effected.  Based on this decision, it appears likely that a Massachusetts court facing a similar issue will construe these agreements strictly and will require the exclusivity and revocability to be expressly stated to be enforceable.

If you have any questions regarding the issues discussed in this point, please feel free to contact us.

Footnotes:

 

(1) ”Any Disputed Claim and any other dispute which may arise under this Escrow Agreement with respect to the rights of [Astra Tech] or any other Indemnified Party and the Shareholders’ Agent or the Company Securityholders to the Escrow Fund shall be settled by mutual agreement of [Astra Tech] and the Shareholders’ Agent (evidenced by joint written instructions signed by [Astra Tech] and the Shareholders’ Agent and delivered to the Escrow Agent); provided, however, that upon receipt of a copy of a final and nonappealable order of a court of competent jurisdiction with respect to payment of all or any portion of the Escrow Fund, … the Escrow Agent shall deliver the portion of the Escrow Fund specified in such award or order to [Astra Tech] or other Indemnified Party and/or the Shareholders’ Agent for the benefit of the Company Securityholders as directed in such award or order.”

(2)  ”[T]he Shareholders’ Agent shall be, and hereby is, appointed and constituted in respect of each Company Securityholder, as his, her or its agent, to act in his, her or its name, place and stead, as such Company Securityholder’s attorney-in-fact, as more fully set forth in this Section 8.6. Without limiting the generality of the foregoing, the Shareholders’ Agent shall be constituted and appointed as agent for and on behalf of the Company shareholders to give and receive notices and communications, to authorize delivery to [Astra Tech] of the monies from the Escrow Fund in satisfaction of claims by [Astra Tech] Indemnified Persons against the Escrow Fund, to object to such deliveries, to agree to, negotiate, enter into settlements and compromises of, and demand arbitration and comply with orders of courts and awards of arbitrators with respect to such claims, and to take all actions necessary or appropriate in the judgment of the Shareholders’ Agent for the accomplishment of the foregoing.” [FN13]

Section 8.6(e) further delineates the actions that may be taken by the shareholders’ agent:

“A decision, act, consent or instruction of the Shareholders’ Agent shall constitute a decision of all Company shareholders … and shall be final, binding and conclusive upon each such Company shareholder, and the Escrow Agent and [Astra Tech] may rely upon any decision, act, consent or instruction of the Shareholders’ Agent as being the decision, act, consent or instruction of each and every such Company shareholder.”

 

 


Recent MA SJC Noteworthy Decision, so to speak

Posted on Apr 19th, 2013

A recent decision by the Massachusetts Supreme Judicial Court is noteworthy for transactional practitioners:

In T. Butera Auburn vs. Williams, the Court held that a purchaser of a veterinary business was not entitled to withhold payment on a promissory note issued in connection with the purchase of defendant’s business.  The case involved the purchase of a veterinary clinic business from the defendant via an asset purchase agreement, where $800,000 was paid at the closing, the another $400,000 was payable via a promissory note over 15 years.  According to the decision, when plaintiffs discovered that the defendant was in violation of her covenant not to compete and other post-closing obligations, they brought suit and sought to hold back payment on the note to set off their damages.  Plaintiffs argued that they were excused from performance under the Note based on language on the APA that a default under a related transaction document (such as the Note) would be a default under the APA.  The Court rejected this argument, noting that this case involved the opposite scenario.  Here the breach occurred under the APA provisions, not the Note, and the Note did not contain a cross-default provision that would have potentially allowed the Plaintiffs to stop payment.  The Court did comment however, that if the plaintiffs could have shown that “the damaged business itself was supposed to generate the income from which the debt … was to be repaid, [the defendant] might well be estopped from obtaining judicially compelled acceleration on the basis that the Note was breached when payments were not subsequently made on time by the borrower.”

This case is a useful reminder that:

  • cross-default provisions and rights for setoff in the event of an indemnification or other claim should be included in Notes and other transactional documents
  • Language such as that quoted below may be helpful to add as an acknowledgment to a remedies section in the transaction documents to prevent a similar result

 


Recent decision by Massachusetts Supreme Judicial Court Strictly Construes Transfer Restrictions and Co-Sale Rights in S Corporation

Posted on Apr 19th, 2013

 

Since the 1974 landmark decision in Donohue v. Rodd, Massachusetts courts have held that majority stockholders in close corporations owe minority stockholders a fiduciary duty akin to that owed in a partnership. This type of duty has been relied up to protect minority shareholders from squeeze-out or freeze-out scenarios. It has also been used as an offensive tactic to argue for implied rights of shareholders that are not expressly provided in the corporate documents, such as the articles of organization, bylaws or shareholder agreements.

In Merriam, et. al. v. Demoulas Supermarkets, Inc., the Supreme Judicial Court refused to extend the duties provided under Donohue v. Rodd to restrict stock transfers that were not expressly restricted under the Corporation’s governing documents.

While a fiduciary duty may exist, the Court encouraged shareholders of close corporations to enter into a shareholder agreement or specify in the corporate bylaws “rights, protections, and procedures that define the scope of their fiduciary duty in foreseeable situations.” The Court held that good faith compliance with the specific terms will not implicate that fiduciary duty. “A claim for breach of fiduciary duty may arise only where the agreement does not entirely govern the shareholder’s actions.”

In this case the plaintiffs attempted to use the concept of fiduciary duty in a creative way to prevent the transfer of stock because the corporation was an S corporation and the transfer could blow the S election. After reviewing the shareholder agreement and bylaws, the Court held that the challenged actions fell within the scope of those agreements – which did not restrict such a transfer – and that the fiduciary duty was not implicated in this case.

The court also rejected the argument that the fiduciary duty could be used to create an implied right of first offer or co-sale rights on a transfer to a third party. Transfer restrictions are to be construed narrowly in Massachusetts, and the Court reasoned that had the parties intended to create such rights and restrictions, they would have stated so expressly in their shareholder agreement.

Certainly, this decision does not present any major news to most corporate practitioners. While it is nice to know that shareholder agreements are still given weight in Massachusetts, the key takeaway is the importance of having such an agreement in the first place. Close corporations, particularly those with employee shareholders, should be strongly encouraged to enter into detailed shareholder agreements to provide for situations dealing with transfers, rights of first refusal, preemptive rights and potential divorce and dissolution. Majority stockholders may feel some reluctance to spend money and time on such a document, when the protection is often for their fellow stockholders. However, as shown by this decision, not having such an agreement will subject everyone to the vague principles of applicable fiduciary duties, which could have wide-ranging and negative implications.

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


Recent Massachusetts Supreme Judicial Court decision summarizes Massachusetts Law on Statute of Limitations on Promissory Notes and Successor Liability

Posted on Apr 17th, 2013

If you look at promissory note in your form file, odds are that the signature line indicates that the note was signed “under seal.” Aside from custom, there are several reasons why this somewhat archaic language was included. The most important reason, at least in Massachusetts, was that the language elevated the note from a plain contract to a sealed instrument. This extended the statute of limitations relating to the Note from six years to twenty.

In 1998, in connection with the revision of Article 3 of the UCC, Massachusetts adopted G. L. C. 106, § 3-118, which provided for a uniform six year statute of limitations for all negotiable instruments. In its recent decision in Premier Capital, LLC v. KMZ, LLC, the Massachusetts Supreme Judicial Court held that Section 3-118 governs all negotiable instruments, sealed and unsealed. However, to the extent that a cause of action predates this adoption of law, the Court held that the law in effect prior to 1998 will apply. As there are probably few instruments still lying around that predate this adoption, odds are that we may start see the “under seal” language slowly disappear from these types of documents.

The other significant aspect of this decision is the Court’s concise restatement of Massachusetts law on successor liability. (The issue in the case was whether a promissory note could be enforced against KMZ, an entity that the plaintiff claimed to be a successor in interest to Max Zeller Furs, Inc., the party that signed the original note.)

First, in order to be deemed a “successor corporation”, there must be a transfer to that entity of “all or substantially” of another corporation.

If the first test is met, then to impose liability on the successor corporation, one of the following factors must also be met:

  • the successor assumes the predecessor’s liability expressly or impliedly
  • the transaction is a “de facto merger”
  • the succession is merely a continuation of the predecessor, or
  • the transaction is really just a fraudulent attempt by the predecessor to avoid liability.

Here, the Court affirmed the ruling in favor of the defendants, holding that there were no undisputed facts proving that Zeller transferred “all, or substantially all” of its assets to KMZ. While Premier argued that Zeller transferred its good will to KMZ, it could not show any actual agreement memorializing that transfer. The court also held that engaging in the same business and having the same stockholders, without meeting the transfer test, was not enough.

The take away from this case is that successor liability can only be established with a clear showing of facts within the established guidelines of the case law. Courts are not likely to find successor liability for purposes of summary judgment without undisputed proof of transfer of liability.

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


Delaware Court of Chancery Holds that a Reverse Triangular Merger is not a Transfer or Assignment by Operation of Law

Posted on Mar 13th, 2013

 

Last month the Delaware Chancery Court allayed the concerns of corporate transactional lawyers by ruling under Delaware law that a reverse triangular merger (RTM) does not constitute a transfer or assignment by operation of law. The decision, Meso Scale Diagnostics, v. Roche Diagnostics, C.A. No. 5589-VCP (Del. Ch. 2013), involved a restriction on assignments and transfers in a license agreement, which the Court held as a matter of law was not triggered by the RTM.

In brief, a reverse triangular merger structure involves a merger of a selling company (Target) with a subsidiary of the buyer company (Buyer), which is often a special purpose entity created just for the transaction. The transaction is referred to as a “reverse” type of merger because the acquired entity here ends up being the surviving entity in the merger and becomes a subsidiary of the Buyer. This structure is desirable because it resembles a stock acquisition in its final result, but has the added advantages of (1) requiring less than unanimous approval from the Target’s stockholders and (2) allows for more flexibility than a stock swap under the tax laws relating to what are called “tax free” reorganizations.

For years, corporate lawyers have taken the position that a RTM does not trigger anti-assignment provisions in contracts. That’s because in this structure, just like in a stock acquisition, no contracts are being assigned or transferred per se. The acquired entity remains in place and the only change is that its stockholders before the deal have been replaced with a single stockholder, which is either the Buyer or one of its subsidiaries. However, starting with a somewhat obscure 1991 California court decision involving Oracle, there has been a growing national trend of courts calling this line of reasoning into question. The Oracle court reasoned that a change of stock ownership in a target was a change of its legal form, which resulted in an impermissible transfer of intellectual property rights. Most recently, an earlier Chancery Court decision in 2011 in this same case created ambiguity under Delaware law – previously thought to be safe territory by most Delaware practitioners – by refusing to dismiss the case based on the stock acquisition cases cited by the defendants.

The recent Meso Scale holdings resolve these issues. The Chancery Court rejected the Oracle decision as persuasive authority on this issue. The Court reasoned that the California court’s holding that a RTM constitutes an assignment by operation of law conflicts with Delaware’s jurisprudence regarding stock acquisitions. This is because Delaware courts have consistently found over time that when a corporation lawfully acquires the ownership of another corporation and with it the corporation’s stock, this change of ownership does not imply any assignment of the contractual rights of the corporation whose securities the buying corporation purchased. Therefore, the Court of Chancery held that because both stock acquisitions and RTMs are changes in legal ownership, and not in the underlying interest of that entity, they should produce parallel legal results.

The lessons from this case are two-fold:

1.   For contracts governed by Delaware law, parties can continue to rely on stock acquisitions and RTMs as a structure where third party consents should not be required to a “transfer” or “assignment” type of contractual clause. For contracts governed outside Delaware, such as in California, the doubt still remains, so it may be prudent to get the third party consent for those contracts just in case.

2.   For Delaware-governed contracts, parties that want the right to consent to a RTM (or other similar transaction) should include a “change of control” provision in their contracts. While this is common in more complex agreements, such as financing agreements and real estate leases, commercial agreements such as software license agreements and customer and vendor contracts generally do not go to this level of drafting.

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