July 28, 2006

Damages for Lost Merger Premium Under New York Law

Kevin Miller of Alston & Bird notes: As many of you probably are aware, the Court of Appeals for the Second Circuit applying New York law held last year that under the “no third-party beneficiary” provision typically found in most public company merger agreements, the target company could not recover lost merger premium as damages for the acquiror’s wrongful termination/failure to close. The case was Consolidated Edison, Inc. v. Northeast Utilities, 426 F.3d 524 (2d Cir. 2005); here is a copy of the opinion.

The Second Circuit Opinion

A substantial rationale was that lost merger premium is a damage suffered by the target’s stockholders, not the target, and the target’s stockholders are not entitled to recover damages unless they are intended third party beneficiaries – something the target and buyer would be loathe to agree for fear of losing control of the transaction.

As noted in the ConEd/NU decision, the direct damages suffered by NU were less than $30 million on a $3.6 billion dollar transaction, while the lost merger premium was over $1 billion.

Generally, the target’s expenses will represent a smaller percentage of the overall transaction value as the size of the transaction increases. Nevertheless, until recently, no large publicly company merger agreement governed by New York law appeared to contain a provision in which the target insisted on language intended to create a meaningful disincentive for buyers who, presumably suffering buyer’s remorse, might wrongfully terminate or fail to close a merger if the potential damages were limited to the relatively modest costs and expenses and not lost merger premium.

The Phelps Dodge-Inco Combination Agreement

The Combination Agreement between Phelps Dodge Corporation and Inco Limited, dated as of June 25, 2006, however, contains the following provision:

“10.4. Entire Agreement; Third Party Beneficiaries. This Agreement and the documents and instruments and other agreements among the parties hereto . . . are not intended to confer upon any other person any rights or remedies hereunder, except (i) as specifically provided in Section 7.6 and (ii) the right of [Inco’s] shareholders to receive Portugal Common Shares and cash at the Effective Time and to recover, solely through an action brought by [Inco], damages from [Phelps Dodge] in the event of a wrongful termination of this Agreement by [Phelps Dodge].”

Inco stockholders are clearly made intended third party beneficiaries with the right to recover damages (which would likely include lost merger premium) in the event Phelps Dodge wrongfully terminates the merger agreement, but only through an action brought on their behalf by Inco. Thus, the third party beneficiary rights explicitly created by contract are also explicitly limited by contract to prevent Inco stockholders from attempting to enforce those rights individually or as a class representative.

The provision nevertheless leaves a few questions unanswered:

– Since Inco only has the right to bring an action on behalf of Inco stockholders, how would Inco distribute the proceeds of such action? This is an issue the federal district court in ConEd/NU had struggled with but the Court of Appeals never addressed – do the damages belong to the stockholders of the target at the time of the breach or at the time of the judgment? Alternatively, could you vest the right to the recovered damages with the target itself (rather than merely the right to enforce the contract on the stockholders’ behalf) or specify that the right to recover damages transfers with shares of stock until the judgment date which effectively becomes the record date for the distribution of damages on a pro rata basis?

– What if the buyer doesn’t terminate the agreement but merely refuses to close, alleging the failure of a closing condition? [NU alleged this to be an effective termination but the issue was left unresolved by the Court of Appeals]

– Would courts applying Delaware law handle this situation differently?