March 12, 2009

Customary M&A Indemnity Provision Gives Rise to Breach of Loyalty Claim

– by John Jenkins, Calfee Halter & Griswold

Public company merger agreements frequently contain provisions under which a buyer agrees to cause the surviving corporation to indemnify the seller’s directors to the same extent that they are currently indemnified “or to the fullest extent permitted by law.” While this is pretty standard practice, language like this can provide a seller’s directors with much broader indemnity rights than they would be able to obtain from the seller itself. That is usually good news for a seller’s board, but not always.

That point was brought home last month when a Tennessee appellate court, applying Delaware law, refused to dismiss duty of loyalty claims against a seller’s directors premised on the inclusion of customary director indemnity arrangements in a merger agreement.

In Indiana State District Council of Laborers v. Brukardt, No. M2007-02271-COA-R3-CV (Tenn. App. Feb. 17, 2009) the Tennessee Court of Appeals overruled a trial court’s dismissal of a shareholder class action lawsuit against the board of directors of Renal Care, Inc., a health care company that was acquired by Fresenius Medical Care AG in 2005. Among their other allegations, the plaintiffs contended that the defendants breached their fiduciary duty of loyalty by entering into the merger in order to “cover alleged Medicare fraud and back dating of stock options, [and] also to insure that they would be free of any possible liability for such acts.”

In dismissing the plaintiffs’ loyalty claim, the trial court held that a majority of the Board had no conflicts of interests. The appellate court disagreed, noting that the plaintiffs had alleged that “by engineering the merger which included indemnification, all defendants were able to significantly minimize their exposure to liability in connection with the alleged brewing problems at Renal Care.”

The defendants contended that no conflict of interest existed between the interests of directors and shareholders when the indemnity rights given them under the merger agreement were “essentially duplicative” of rights that they already had, but the court disagreed:

“First as a matter of Delaware law, Renal Care could only indemnify defendants for “acts in good faith and in the best interests of the corporation.”But Fresenius, as a third party indemnifying Renal Care directors, is not bound by “the restrictions of statutory corporate law” and can extend indemnifications to defendants for breaches of the duty of loyalty and good faith.”

In reaching this conclusion, the court cited the Delaware chancery court’s decision in Louisiana Mun. Police Employee’s Ret. Sys. v. Crawford, 918 A.2d 1172, 1180 n. 8 (Del. Ch. 2007). In that case, the chancery court characterized the distinction between the indemnification that a buyer could provide and that which the seller could provide its own directors as being “quietly critical.” In the present situation, the court believed that under Delaware law, “the indemnification offered by Fresenius covers defendants’ liability for option backdating, a breach of the duty of good faith, whereas the indemnification offered to defendants by Renal Care could not.”

Crawford involved the CVS/Caremark transaction and attracted a lot of attention when it was decided. At the time, most of the discussion surrounded the court’s decision that Caremark’s shareholders had appraisal rights in a purported stock-for-stock merger because a special dividend declared in connection with transaction should be considered part of the merger consideration.

The Chancery Court’s discussion of the distinction between the rights to indemnity that a director could obtain from his or her corporation and those that a buyer could provide was confined to a footnote. Nevertheless, as the Tennessee Court of Appeals decision in Laborers v. Brukardt suggests, that footnote may have some pretty important implications for those involved in mergers and acquisitions.