In most mergers, the buyer and seller are each represented by legal counsel. The stockholders of the selling company often assume that communications with the law firm that “sat on their side of the table” in the negotiation phase of the transaction will continue to be confidential and unavailable to the buyer since it was the adverse party during the negotiation phase. That analysis, however, fails to take into account the actual nature of the attorney-client relationship. With most deals, the law firm’s client is the selling company, not its stockholders. At closing, the target company typically becomes a wholly owned subsidiary of the buyer. Therefore, there has been some question as to whether rights to the legal privilege and the attorney-client relationship flow to the buyer with respect to pre-closing communications.
In Great Hill Equity Partners IV, LP v. SIG Growth Equity Fund I, LLLP, C.A. No. 7906-CS (Del. Ch. Nov. 15, 2013), the Delaware Chancery Court addressed this issue and determined that the selling company’s attorney-client privilege related to pre-closing communications transferred to the buyer following closing. The court focused on the statutory language of Section 259 of the Delaware General Corporation Law, which says that following a merger, “all [of the target company’s] property, rights, privileges, powers and franchises, and all and every other interest shall be thereafter as effectually the property of the surviving or resulting corporation . . .” (emphasis added).
The court suggested that the target company could have avoided this outcome if desired by specifically excluding such privilege rights from being transferred to the buyer in the contract language of the merger agreement. It then cites examples of asset purchase transactions in which this was done. In our view, however, there are a number of questions that remain unanswered by the court’s decision. We address those below and suggest possible solutions to mitigate the associated risks.
A. With transactions structured as mergers, how do the sellers retain the privilege?
When the transaction is structured as an asset purchase, this is relatively simple in most cases. The selling company remains an independent legal entity, and to make clear that the privilege is not transferred, it can be included in the list of assets specifically listed as “excluded assets” in the purchase agreement. In contrast, with mergers, the target company typically becomes a wholly owned subsidiary of the buyer, meaning the buyer would ordinarily acquire control of the privilege. Therefore, the privilege must somehow be transferred out of the surviving corporation and to another sell-side entity.
Such a transfer might not be as simple as the Great Hill court seems to imply. An attempted transfer of the target’s former stockholders would be difficult and would leave the question as to whether the result is that dozens or hundreds of separate individuals and entities would then each own that privilege. The target company may instead desire to have its privilege rights transferred upon closing to a single entity, such as a large stockholder or the post-closing stockholder representative. The Great Hill court did not address how such a transfer could be structured, but we believe it would be more complicated than simply stating in the merger agreement that a party other than the buyer will hold the privilege upon and following closing. A court would have to accept how a new party came to hold the privilege and conclude that such a transfer was effective.
The uncertainty around this issue is clear from the wide variety of new language we see in agreements trying to address this. Some state that the privilege is assigned to the shareholder representative, some say that it is assigned to all shareholders and the shareholder representative, and some simply say that it is not transferred to the buyer without assigning it to anyone. This seems to pretty strongly indicate that we are far from having consensus on how this issue should be handled.
B. Even if the privilege can be transferred, how do the sellers avoid an immediate waiver?
The Great Hill court noted that the target company did nothing to prevent the disclosure of the relevant communications to the buyer for over a year following closing. The court, however, did not address the issue of whether this would have constituted a waiver because it was not necessary to tackle that question once it had already concluded that the buyer owned the privilege following closing.
Therefore, the question remains that even if the target is successful in preventing the privilege from being transferred to the buyer, how can they prevent that privilege from immediately being waived? A waiver could be deemed to have occurred for a couple reasons.
First, the privilege could be deemed waived for the reason implied in Great Hill if the buyer obtains access to such communications following closing. Some agreements are now including language that says the buyer will not have access to such communications, but that probably is not accurate. While they might not have access to the attorney’s files, many communications will exist on servers or in files that the buyer will take over and could access intentionally or inadvertently. Since, in this scenario, a party that does not hold the privilege was able to access the contents of the related communications, a court would likely find that the applicable privilege has been waived. The parties could include language in the merger agreement similar to “clawback and non-waiver” provisions found in protective orders in the discovery context to try to prevent this. Such language would state that any post-closing access by buyer to such communications will not waive or otherwise affect the rights of the selling stockholders or their representative with respect to the related privilege. Since Great Hill did not address that issue, it is unclear whether such a “privilege savings clause” would work. We note, however, that we do not see it included in many of the new clauses that are attempting to address this.
Second, unless the courts accept a legal fiction that the target company and all its employees “forget” the privileged information upon transfer to an assignee, pushing them outside the zone of privilege by virtue of a transfer could function as a waiver. Therefore, even if the sellers are successful in preventing the buyer from ever obtaining any relevant communications, the fact that parties who no longer “own” the privilege have actual or constructive knowledge of the contents of such communications may still be deemed to cause a waiver of such privilege upon transfer.
C. What is the scope of the communications that should be subject to any privilege retained by the sellers?
In Tekni-Plex, Inc. v. Meyner & Landis, 674 N.E.2d 663 (N.Y. 1996), the New York Court of Appeals ruled that privileged communications related to the merger transaction itself are retained by the sellers, but rights with respect to other attorney-client communications are transferred to the buyer. For instance, if the target company’s law firm had represented them over the years prior to the merger transaction with respect to other matters such as intellectual property or general litigation, the buyer would acquire all rights to all communications associated with those issues, but would not acquire rights to communications related to the merger transaction itself.
Merger parties that agree that the selling stockholders should retain privilege rights with respect to certain communications but not others might look to the Tekni-Plex ruling as a framework in defining which privileged communications would remain with the selling stockholders and their representative, and which would transfer to the buyer. One issue with this analysis is that there are some communications that would likely fall in a gray area. For instance, if the target asks their attorneys to do an analysis of third-party intellectual property rights because they want to understand any risks to their operations, but that analysis also turns out to be relevant to what they include in a disclosure schedule attached to the merger agreement, is that related to the merger or its general operations?
Therefore, even if the merger parties agree that privilege rights to pre-closing communications with counsel related to the merger will not be transferred to the buyer, the line as to what is intended to be included and excluded from that definition may be a little fuzzy.
Many agreements we see are now including language attempting to assign the privilege to the stockholders and/or their representative or to preclude the buyer from accessing such communications. The suggestions below are possible additional steps that can be taken in case such new language ultimately does not work.
1. “Quarantine” Pre-Closing Communications with Counsel with a Covenant from the Buyer Not to Attempt to Access Them.
When determining how the target company’s merger team and the company’s counsel are going to communicate pre-closing, it may be necessary to set up a communications systems separate from the target’s email and to specify in the merger agreement that all electronic and hard copies of such communications will be effectively walled off from other company systems and communications. The parties could couple this with a provision in the merger agreement in which the buyer and target covenant not to attempt to access any such communications following closing. This could have the effect that even if the privilege did flow to the buyer upon closing, such communications would be unavailable to them.
2. Allow the Buyer to Access the Applicable Communications but Limit Permitted Uses.
If the parties do not agree that the buyer will be prevented from accessing the applicable communications following closing, they could instead include a clause in the merger agreement that says that the buyer cannot use any such communications or the contents thereof against the selling stockholders or their representative in connection with any disputes related to the merger agreement. As with alternative #1 above, this might not prevent the privilege from transferring to the buyer and has the obvious drawback for the selling stockholders that the buyer would be able to see the contents of such communications, but it could ameliorate the risk of those communications being used against them.
3. Common Interest Agreement (CIA) Between the Target and the Stockholder Representative or a Major Stockholder.
Another alternative to effecting an assignment of rights to privileged communications or to preventing such rights from being transferred to the buyer in a merger would be to have the target and the stockholder representative or a major stockholder (either, a “Representative”) enter into a CIA with the target’s attorneys prior to closing. The CIA could acknowledge joint access of the target and the representative to the privileged material, but reserve the right to waive the privilege to the representative alone. As with alternative #2 above, this likely would not prevent the buyer from accessing privileged materials, but could prevent them from disclosing or using such materials in litigation. This presumably would leave the representative the option to use, or prevent the use of, that material in any dispute.
Furthermore, most CIAs include a provision stating that each party agrees that they cannot use any privileged communications against the other if the parties’ interests diverge at any point. Since the interests of the stockholder representative and the target with respect to such communications presumably are aligned prior to closing but diverge upon closing with respect to disputes under the merger agreement, this divergence of interests provision in the CIA should take effect and further support the argument that the buyer is barred from being able to use the applicable communications in disputes against the sellers.
Additionally, using a CIA may have an added benefit over the preceding alternatives of helping to ensure that the Representative is able to access pre-closing communications with the target’s counsel. In Great Hill, the sellers were trying to prevent the buyer from accessing or using the privileged communications, but the opposite consideration is often in play. Rather than sellers trying to block the buyer’s access, the sellers are often trying to gain access to certain materials or communications to bolster their defense against a claim. Having a CIA in place could make clear that the representative has rights to access such materials.
Finally, a CIA likely does not need the approval of a buyer who is required to add a covenant or restrictive provision to the merger agreement as contemplated in alternatives #1 and #2 above.
Until the courts are able to further clarify if and how the parties can transfer the target company’s privilege rights in pre-closing communications to another sell-side entity or prevent such rights from flowing to the buyer, these suggestions may be the best options available to provide the target stockholders with as much protection as possible.
The issues addressed in this article raise new and complex challenges that require sophisticated legal analysis on each transaction. Prior to entering into any such transaction, you should consult with legal counsel.