Devils in the Details: an Essay Examining the Significance of Jurisdictional Default Rules in the Mergers and Acquisitions Context

• Jurisdiction: United States,Federal
• Publication year: 2017
• Citation: Vol. 4 No. 2

Devils in the Details: An Essay Examining the Significance of Jurisdictional Default Rules in the Mergers and Acquisitions Context

Adrian Szycowski

DEVILS IN THE DETAILS: AN ESSAY EXAMINING THE SIGNIFICANCE OF JURISDICTIONAL DEFAULT RULES IN THE MERGERS AND ACQUISITIONS CONTEXT

Choice of law is one of those concepts that law school professors love to focus on in different courses. However, the concept raises the question: does choice of law make a practical difference? The short answer is no. Generally speaking, laws between U.S. states rarely diverge to the degree that would prompt individuals to sue exclusively in state X over state Y. Differences in laws between U.S. states carry de minimis value and only become a heightened concern on a specific case by case basis. There are exceptions to this general rule. In the realm of mergers and acquisitions ("M&A"), U.S. state laws and court opinions addressing "sandbagging,"¹ waiver of jury trial, and non-compete provisions are several of these exceptions. For example, it is universally agreed in the M&A world that Delaware, New York, and California are, respectively, "pro-sandbagging," neutral/ambiguous toward sandbagging, and "anti-sandbagging." But why are there differences and why do they matter? This Essay attempts to answer these questions as well as provide an analysis of the three aforementioned provisions found in M&A agreements nationwide.

First, this Essay will outline its scope and goals accompanied by a brief foundation of mergers and acquisitions. Second, it will demonstrate the effect of a jurisdiction's default rule in an M&A deal followed by a detailed discussion of each M&A provision—sandbagging, waiver of jury trial, and non-compete—and various jurisdictional default responses. Third, it will put forward alternative theories and reasons why Delaware, New York, and California approach sandbagging, waiver of jury trial, and non-compete provisions in their respective ways.

Introduction

Before this Essay continues with its analysis of the above-mentioned M&A provisions and varying jurisdictional treatment of those provisions, a brief foundation of M&A is needed. The terms mergers and acquisitions are often

[Page 442]

used interchangeably; however, the two terms are fundamentally different. Without getting into an advanced discussion, an acquisition refers to one business entity buying another either in its entirety or in part.² On the other hand, a merger refers to two separate business entities combining together to form a completely new business entity.³ Therefore, although the two terms are used interchangeably, it is important to know they refer to two different situations and should not be used synonymously.⁴

Broadly defined, mergers and acquisitions are one of many corporate tools at the disposal of corporate officers, boards of directors, and shareholders⁵ in stimulating growth for their organizations. While 2016 has been characterized as a "bumpy year"⁶ for M&A activity, a recent survey conducted by a "Big Four" accounting firm, Deloitte, LLP, asked 1,000 corporate and private equity investors to weigh in on what they thought 2017 would hold for M&A activity.⁷ The survey's results indicated that roughly 75% of the investors believe M&A activity will increase in 2017 and, more importantly, 64% of the respondents believe respective deal sizes will increase as well. Given the expected increase in M&A activity, this is an opportune time to study M&A transactions and how they may vary from state to state.

This Essay's scope is primarily centered on the case study of the three M&A provisions—sandbagging, waiver of jury trial, and non-compete—and their respective treatment in Delaware, New York, and California. These three common provisions found in M&A agreements were chosen for examination because they highlight various jurisdictions' divergent approaches. The jurisdictions of Delaware, New York, and California were chosen because each state is highly representative of its respective category of jurisdiction. Moreover, these three states see their fair share of M&A deals.⁸ This Essay

[Page 443]

does not close the door on mentioning other states' treatment where relevant and by no means does it intend to provide a state by state legal survey of each state's approach towards various M&A provisions. This Essay has two simple goals. First, to highlight the importance of considering how a specific jurisdiction's approach may affect a M&A transaction and negotiation. Second, to answer why Delaware, New York, and California have taken their respective stances. In working towards these goals, this Essay will also answer why a choice of law decision exists to begin with and why there is competition among the states in the M&A realm.

I. Sandbagging, Waiver Of Jury Trial, And Non-Compete—Why Do The Differences Matter?

To illustrate the importance of these three provisions and their respective treatment, what follows is a hypothetical demonstrating the effect of sandbagging. Imagine in the eleventh hour of a several yearlong negotiated asset purchase agreement to acquire assets from Business S that Business B finds an inaccuracy during their due diligence of Business S's corporate records. At this point, Business B must decide whether to disclose the inaccuracy to Business S, which may further prolong the negotiations and the overall timetable of the already lengthy deal, or to continue to closing and not inform Business S of the inaccuracy. For obvious reasons, the former is undesirable to Business B, especially given the facts. However, the aftermath of the latter raises a couple of questions. While inaccuracies in corporate records do not always cause noteworthy issues, it may turn out that the inaccuracy causes a significant misrepresentation or breach of warranty by Business S in the asset purchase agreement. Should Business S be liable to Business B for damages sustained from the misrepresentation or breach? Should Business S be liable to Business B if Business B knew about the misrepresentation or breach ahead of time and chose not to disclose it to Business S, who might have been able to remedy it before the closing of the deal?

Although this illustration may appear trivial on its face, the answers to the questions above determine whether years of hard work along with millions of dollars go to waste. For example, Jurisdiction X may rule in favor of Business S and force Business B to bear the costs. At the same time, Jurisdiction Y may

[Page 444]

rule in favor of Business B and force Business S to remedy Business B's losses. A real-world example follows demonstrating the monetary impact a default rule may have. In Cobalt Operating, LLC v. James Crystal Enterprises, LLC,⁹ Delaware's pro-sandbagging default rule allowed the buyer in an asset purchase agreement to recover at least $12 million from the $70 million purchase price.¹⁰ Thus, it is prudent for any business entity and its board of directors contemplating a M&A transaction to be privy to the way its jurisdiction(s) treats certain M&A provisions, especially those entities that have footholds in several different jurisdictions. What follows is a breakdown of the three M&A provisions along with how Delaware, New York, and California treat each one and why.

A. Sandbagging

The term "sandbagging" has been said to be associated with the poker strategy of refraining from raising at first in hopes of being able to raise more steeply later.¹¹ Sandbagging occurs in a deal when a party, almost always the buyer, seeks to recover, usually through an indemnification provision, for a misrepresentation or breach of warranty for an inaccuracy that the party had knowledge of prior to the closing.¹² While parties may contract around the action of sandbagging via either pro-sandbagging or anti-sandbagging provisions, it is crucial, especially in high dollar-figure deals, to know what relevant default rules govern a particular jurisdiction are.

In determining whether a jurisdiction is pro-sandbagging or anti-sandbagging, the crux is whether the jurisdiction views the breach of warranty claim as a tort claim or a breach of contract claim.¹³ This distinction is important because, in a tort claim, reliance is a necessary element.¹⁴ If a party knew of the breach of warranty beforehand, it could not argue reliance on the warranty to its detriment.¹⁵ This would be an example of an anti-sandbagging jurisdiction. However, if the jurisdiction views the breach of warranty claim as

[Page 445]

a claim for breach of contract, then a party's pre-closing knowledge is irrelevant because reliance on the truth of the warranty is not a requirement for recovery.¹⁶ This would be an example of a pro-sandbagging jurisdiction.

Originally, Delaware was considered an anti-sandbagging jurisdiction.¹⁷ However, in 2005 the Delaware Superior Court held in Interim Healthcare, Inc. v. Spherion Corp., that reliance was not a requirement for a breach of warranty claim and, more importantly, that the purchaser in the case had the right to rely on the seller's warranties.¹⁸ Subsequently, the Supreme Court of Delaware in James Crystal Enterprises, LLC v. Cobalt Operating, LLC affirmed this latter view and rejected the tort approach when it was presented with James Crystal Enterprises' appeal, which was the real-world example stated earlier.¹⁹ These decisions solidify Delaware, at least for now, as a pro-sandbagging jurisdiction.

As mentioned earlier, New York is a bit more complex in its approach towards sandbagging than Delaware. In CBS Inc. v. Ziff-Davis Pub. Co., the New York Court of Appeals diverged from past court opinions by holding that the breach of contract ideology applied to breaches of warranties and that reliance was still a necessary element of a breach of warranty.²⁰ However, the court also held that reliance could be found if a party relied on the "express warranty as being a part of the bargain between the parties"²¹ rather than if the...