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Drafting Lessons from the Court of Chancery—the Meaning of “Void,” “Subject to,” and “And”

M&A/PE Briefing | October 13, 2022

Three recent Delaware Court of Chancery decisions serve as a reminder of the endless possibilities for lack of clarity in the drafting of contract provisions—and the serious potential consequences of judicial interpretation of provisions that are not fully clear. Even words that are very commonly used in contracts may not be clear in their meaning, as highlighted in these three recent decisions (and numerous others).

In Delaware, when the “plain language” of a contract is “unambiguous” (that is, in the court’s view is “reasonably susceptible to only one interpretation”), the courts will construe the contract in accordance with the “plain meaning” of the language and will not consider extrinsic evidence to determine what the parties’ intentions were. The determination of the plain meaning typically relies on an analysis of the language “in context”—that is, with a focus on how the provision at issue relates to the other provisions of the agreement and to the agreement as a whole.

Accordingly, drafters of contracts should pay careful attention to every word in an agreement and to the (often complicated) relationship of provisions in an agreement to one another. While some level of lack of clarity may be inevitable in most agreements notwithstanding intense effort by the drafters to avoid it, drafters should be aware of those words, phrases, and agreement provisions that the court has identified as generally being potentially ambiguous, and should consider providing added clarity through supplemental language, at least for those provisions in an agreement, or those issues relating to a transaction, that may be of particular importance or concern.

Key Points

  • Use of the Word “Void” in a Transfer Prohibition Provision—XRI Investment Holdings LLC v. Holifield (Sept. 13, 2022). The court interpreted a provision in an LLC agreement that stated that any transfer of a member’s interest made in violation of the transfer prohibitions set forth in the agreement would be “void.” The transferor had proved all of the elements of the equitable defense of acquiescence by the LLC, but the court held that he could not assert the defense because the agreement provided that such a transfer was “void” rather than “voidable”—meaning, the court held, that the transfer was “incurably void ab initio.” Vice Chancellor Laster stated that he was compelled to reach this “inequitable” result based on binding precedent. He urged the Delaware Supreme Court to consider rejecting the concept of "contractually specified incurable voidness”—so that the word “void” in a contractual provision would be interpreted as meaning only “voidable.”
  • Use of the Phrase “Subject to” in an Assumption of Liabilities Provision—ITG Brands, LLC v. Reynolds American, Inc. (Sept. 30, 2022). The court interpreted an Assumption of Liabilities provision in an asset purchase agreement that stated that, subject to the Agreed Assumption Terms, the buyer assumed post-closing liabilities relating to certain preexisting settlement payments to a third party. The Agreed Assumption Terms required that the buyer use reasonable best efforts to obtain the third party’s consent to the assumption. The issue arose whether, assuming that the buyer had used the required efforts but failed to obtain the consent, it had fulfilled all of its obligations relating to the settlement payments (or, instead, whether the liability nonetheless was assumed and the buyer was obligated to indemnify the seller for the post-closing settlement payments the seller made. In an earlier ruling, the court had found that the “subject to” phrase created ambiguity such that the case could not be resolved at the pleading stage. In this recent decision, the court held that the phrase “subject to” did not nullify the buyer’s obligation, as between it and the seller, to assume the liability—and, therefore, the buyer was required to indemnify the seller.
  • Use of the Word “And” in a List of Trigger Events for a Call Right—Weinberg v. Waystar, Inc. (July 6, 2022). The court interpreted a stock option agreement that stated that the company had a call right if the employee grantee (x) was terminated for any reason “and” (y) had violated a restrictive covenant. The company terminated the employee and exercised the call right; both parties agreed that the employee had not violated a restrictive covenant. The court held that the company was entitled to exercise the call right because, read “in context,” it was “unambiguous” that the word “and” (used as it was in a “permissive sentence”) effectively meant “or.”

Discussion

The Word “Void” (Rather than “Voidable”) Means “Incurably Void Ab Initio” and Thus Precludes the Assertion of Equitable Defenses to the Voided Act—XRI Holdings

A co-founder of XRI Holdings LLC transferred all of his Class B units to his single-member LLC (“Blue”). XRI’s LLC Agreement permitted transfers to an entity wholly-owned by a member, but only if the transfer was made for no consideration. Holifield’s transfer was made as part of a larger transaction pursuant to which he secured a $3.5 million loan for another company he owned, Entia. The court held that the transfer therefore was for consideration and violated the LLC Agreement. The LLC Agreement provided that any transfer in violation of the agreement would be “void.” Vice Chancellor J. Travis Laster found that Holifield proved the equitable defense of acquiescence—i.e., XRI, knowing all the relevant facts about the transfer to Blue and the larger transaction, took a series of actions that caused Holifield to believe, reasonably and in good faith, that XRI did not object to the transfer). Indeed, XRI’s other co-founder and CEO had worked with Holifield to obtain the financing for Entia; and, ten months after the transfer to Blue, XRI’s legal counsel had analyzed the transfer and concluded that it violated the LLC Agreement but XRI’s governing board had made a business decision not to pursue it (in part because XRI benefitted from it as it isolated the transferred units in a special purpose vehicle and structurally subordinated Holifield’s general creditors).

XRI only decided to challenge the transfer to Blue three years after it took place, when XRI sought, through a “strict foreclosure” process, to seize the transferred units in connection with Entia’s inability to repay when it came due a loan XRI had made to Entia, which was secured by the units. In a strict foreclosure process, any surplus value of the loan security is not received back by the debtor. The court suggested that the transferred units likely had value far exceeding the loan amount, which XRI was seeking to seize. XRI had sent notice of the strict foreclosure to Holifield (rather than to Blue, to which the units had been transferred). XRI brought this suit, seeking a ruling that the transfer to Blue was void—in which case XRI would have sent notice to the correct party as Holifield would have remained the owner of the units.

Vice Chancellor Laster cited as binding precedent the Delaware Supreme Court’s 2018 decision in CompoSecure, L.L.C. v. CardUx LLC, which held that, when an agreement states that a contractually noncompliant act is “void,” then “the plain language of that provision trumps the common law and requires that a court deem the act void ab initio.” Accordingly, the Vice Chancellor concluded that, in the instant case, “by using the word ‘void’ to describe the consequence of a breach of the No Transfer Provision, the parties to the LLC Agreement had opted for a mandatory and exclusive remedy of incurable voidness” (emphasis added). If an act is void ab initio, “a party cannot deploy equitable defenses such as waiver, estoppel, acquiescence, or unclean hands to defeat the claim of breach and defend the contractually noncompliant act. In short, the act is incurably void.” Moreover, the voided assignment was incurable (i.e., could not be waived or fixed) even were the company to have wanted to waive the technical requirements of the provision after the fact—as a void contract is “deemed incapable of confirmation” (except that, with respect to LLC agreements, the LLC Act allows parties to fix a noncompliant act consensually).

While the Vice Chancellor emphasized that this was “an inequitable result” on the facts of this case, he wrote that use of the word “void” “effectively gives private parties the ability to contract out of equity.” The Vice Chancellor included in the 150-page opinion a 45-page rationale on the basis of which, he stated, the Delaware Supreme Court, in connection with any appeal, could reconsider CompoSecure and “permit[] a court of equity to consider equitable defenses to a breach of contract claim, even when the parties have used the word ‘void’ to describe the consequence of contractual noncompliance.” Specifically, he suggested that the ability of contractual parties to dictate voidness ab initio as a selected remedy for breach of an anti-assignment clause should be limited by treating the parties’ use of the word “void” as only meaning that the non-breaching party could treat it as void but was not required to do so (that is, that “void” should be interpreted as having the same meaning as “voidable”). At the same time, the Vice Chancellor emphasized that his suggested approach “does not currently reflect Delaware law.”

The Phrase “Subject to” Does Not Nullify the Main Obligation Unless It Is “Inconsistent” With It—Reynolds American

In 2014, Reynolds American, Inc. sold the Winston, Salem, Kool and Maverick cigarette brands to ITG, L.L.C. for $7.1 billion (simultaneously with Reynold’s merger with Lorillard Inc.). Prior to the sale, Reynolds was making payments to the State of Florida and other states under preexisting litigation settlement agreements relating to alleged misrepresentations by tobacco companies about the addictiveness of cigarettes. The annual amounts payable by Reynolds under the settlement agreements were based on its annual sales of cigarettes. The asset purchase agreement (“APA”), which was governed by Delaware law, provided generally that ITG assumed “aa Liabilities…to the extent arising, directly or indirectly, out of…the use of the Transferred Assets…from and after the Closing.” The APA specified that, “subject to the Agreed Assumption Terms,” ITG would assume Reynolds’ obligations under the state settlement agreements. The “Agreed Assumption Terms, contained in a separate agreement, required that ITG use reasonable best efforts to reach agreement with each state to join the settlement agreement with that state.

Seven years after entering into the APA, ITG still had not reached agreement with the State of Florida and had not made any payments to Florida under the settlement agreement. Florida had brought suit against Reynolds and ITG in Florida. The Florida court had determined that ITG did not assume the liability to make the settlement payments and only had an obligation to use efforts to enter into an agreement with Florida to assume the liability; therefore, the Florida court ordered that Reynolds continued to be obligated to make the settlement payments.

In the instant litigation, Reynolds sought indemnification from ITG for the liability to Florida for the post-closing settlement payments (which amounted to $170 million in payments made and, going forward, tens of millions of dollars each year in perpetuity). ITG argued that, having made reasonable best efforts to reach an agreement with Florida to join the settlement agreement, it had fulfilled its obligations under the APA with respect to the settlement payments—because its obligation to assume the liability was expressly “subject to” its obligation to use such efforts to seek to join the settlement agreement. Vice Chancellor Lori W. Will concluded that, under her interpretation of the APA, as between ITG and Reynolds, ITG had assumed the liability and therefore was obligated to indemnify Reynolds.

The court had held in a 2019 ruling in the case, that the “subject to” phrase in the APA created ambiguity such that the case could not be resolved at the pleading stage. In the instant decision, the court held that, notwithstanding that several provisions of the APA regarding the assumption of liabilities were “potentially conflicting” and that the drafting included “circular ‘subject to’ cross-references,” the APA was “unambiguous” in providing that the post-closing Florida settlement payments were an “Assumed Liability.” The court reasoned that a “subject to” phrase “signals that the main clause it qualifies operates by its terms, unless doing so interferes with the operation of the provision to which the subject-to phrase refers.” “If application of the main clause would be ‘inconsistent with’ the provision to which the subject-to phrase refers, the latter ‘trumps,’” the court wrote.

The court reasoned, further, as follows: (i) It viewed, on the one hand, the allocation of responsibility for “Liabilities under State Settlements,” and, on the other hand, the requirement that ITG use efforts to reach an agreement with Florida to assume the obligations, as “address[ing] entirely different issues.” If Florida’s agreement were obtained, then ITG would have a direct obligation to Florida for the settlement payments, and, if it were not obtained, then ITG would have an indemnity obligation to Reynolds. The two provisions, reflecting “a belt and suspenders approach,” actually “worked together to…ensure ITG (not Reynolds) [would be] responsible for the use of the Acquired Brands post-closing.” (ii) The court noted that the APA provided that ITG assumed post-closing liabilities “arising, directly or indirectly, out of…the use of the Transferred Assets” post-closing. The court viewed the Florida settlement liability as “arising, at least ‘indirectly,’ from ‘the use of the Transferred Assets” post-closing, as the transferred assets were used to sell the acquired brands of cigarettes. “If ITG stopped using the Transferred Assets, it would not be able to sell” the acquired brands of cigarettes; and if ITG “sold no Acquired Brands cigarettes in a post-Closing year, [Reynolds] would have no liability to Florida [under the settlement] for that year.” (iv) Finally, the court observed that interpreting the Florida settlement payments as an Assumed Liability not only was “consistent” with the APA language, but “also provide[d] for [the] logical outcome” that ITG assumed liabilities arising from its post-closing use of the transferred assets.

Depending on the Context, The Word “And” Can Mean “Or”—Waystar

Waystar, Inc. terminated an executive without cause; the executive exercised her right to acquire shares under vested options; and the company exercised a call right to repurchase the shares. The stock option agreement stated that shares issued under the option “shall be subject to the right of repurchase (the ‘Call Right’) exercisable by [the company]…, as determined in its sole discretion, during the six (6) month period following (x) the Termination of such [employee]’s employment…for any reason…, and (y) a Restrictive Covenant Breach [committed by the employee]….”  Both parties agreed that the executive had not committed a Restrictive Covenant Breach (i.e., the event described in clause (x) occurred but the event described in clause (y) had not occurred).

The company argued that the call right, as drafted, could be exercised within six months after (x) occurred and also could be exercised within six months after (y) occurred. The executive argued that the plain meaning of the word “and” in the list of “(x) and (y)” was that the call right could be exercised only if both (x) and (y) had occurred—otherwise, the conjunctive word “and” effectively would be changed to the disjunctive word “or.” Vice Chancellor Sam Glasscock III, citing primarily a 1960 article by Professor F. Reed Dickerson, stated that the word “and” can be used in either a “joint” sense (i.e., “(x) and (y)” means that both (x) and (y) have to have occurred) or a “several” sense (i.e., “(x) and (y)” means that either (x) or (y) or both have to have occurred). The meaning is determined by the context, largely based on whether the word is being used “in a permissive or mandatory sentence.” when “and” is used in a “permissive” sentence, the Vice Chancellor wrote, it is “likely” that it is being used in its “several” sense. In the instant case, the call right provision was a permissive provision in that it granted the company the right to exercise the call “in its sole discretion.” It was thus “natural” to read the word in its permissive (several) sense, the Vice Chancellor reasoned—i.e., the call right could be exercised if either (x) or (y) (or both) occurred.

The Vice Chancellor viewed as further support for a “permissive” interpretation of the word “and” in this case the fact that there was a separate provision in the stock option agreements that would be rendered meaningless if the word were interpreted to require that both (x) and (y) had occurred. The agreements provided for different repurchase prices to be paid by the company when exercising the call right, depending on whether a “Forfeiture Event” had occurred. A “Forfeiture Event” was defined as (a) a termination of the employee’s employment for cause, or (b) the occurrence of a Restrictive Covenant Breach. If the employee were correct that the call right existed only on both termination of employment and a Restrictive Covenant Breach, “then the repurchase price applicable to Forfeiture Events would always apply,” the Vice Chancellor reasoned. “This interpretation would render the repurchase price that applies in the absence of a Forfeiture Event a nugatory.” By contrast, Waystar’s interpretation of the call right could be reconciled with the repurchase price provision: A call right exercised after termination for cause or after a Restrictive Covenant Breach would be subject to the purchase price applicable in the absence of a Forfeiture Event.

The Vice Chancellor found that the call right provision was “unambiguous in context”—that is, the company “was entitled to exercise the Call Right upon [the employee]’s ‘Termination…for any reason,’ regardless of whether she committed a ‘Restrictive Covenant Breach.’”

Practice Points

  • Drafters should strive to provide as much clarity as possible—especially for provisions or issues of particular importance, concern or uncertainty (except to the extent that one or both parties make a deliberate choice in favor of ambiguity to leave space for interpretation). Added clarity may be achieved through supplemental language that is clarifying; adding to the broad language covering an issue specifically how the particular issue would be handled; and/or providing hypothetical examples to illustrate how the parties intend certain provisions to operate. In addition, drafters should consider having provisions of particular importance or concern reviewed by litigators familiar with the transaction.
  • Drafters should avoid common pitfalls leading to a lack of clarity. One area in which a lack of clarity often arises is in the interrelationship of various provisions in an agreement—sometimes due to a hard-to-follow (or even circular) series of cross-references containing the phrases “subject to,” “notwithstanding,” or “except as provided in.” Among the agreement provisions that most often reflect a lack of clarity leading to post-closing disputes are those relating to the assumption of liabilities (as highlighted in Reynolds American); indemnification (including the fundamental issue whether the provision relates only to breaches of representations and warranties or also to breaches of covenants—see, e.g., NASDI Hldgs. v. N. Am. Leasing); and earnouts (including basic issues relating to how the earnout formula works and what actions the buyer is obligated to take to seek to achieve the earnout triggers—see, e.g., Greenstar v. Tutor Perini). Drafters should keep abreast of Delaware judicial decisions interpreting specific words, phrases and provisions. The court has recently addressed the following, for example, with significant effect on how agreement provisions should be drafted: “consistent with past practice” in an ordinary course covenant (Level 4 Yoga v. CorePower Yoga and Edinburgh Hldgs. v. Education Affils.); “calamities” in a Material Adverse Change definition (AB Stable v. MAPS Hotels); the different meanings of “in any event,” “but in any event,” and “provided that” (NASDI Holdings v. N. Am. Leasing); and the different meaning of “in all material respects” versus “Material Adverse Effect,” as well as the similarity of meaning of “reasonable efforts,” “commercially reasonable efforts,” “reasonable best efforts,” and “best efforts” (Akorn v. Fresenius).
  • As highlighted in the three decisions discussed in this Briefing:
    • XRI Holdings: Drafters should understand that a transfer restriction provision stating that a noncompliant transfer would be “void” (rather than “voidable”) deprives both parties of the flexibility to ratify the offending act if the parties desire to do so after the fact and may permit a breaching party to benefit from its breach. Thus, a drafter may wish to consider providing that a specified action in breach of the contract would be “voidable” (rather than “void”); or that it would be “void” but only at the discretion of the non-breaching party; and/or that, if it is “void,” nonetheless equitable defenses (or specified equitable defenses) would (or would not be) permissible. Consideration should be given to this issue also in the other contexts, such as where a corporate bylaw provides that the effect of an action taken in violation of the bylaw will be “void.” (It remains to be seen whether the Delaware Supreme Court, in an appeal of XRI Holdings or otherwise, may follow Vice Chancellor Laster’s suggested approach to permit an interpretation of “void” to mean “voidable.”)
    • Reynolds American: Where the assumption of a liability is “subject to” an obligation to use efforts to obtain third party consent to the assumption (or take other action), the drafter should consider specifying whether the failure to obtain the consent (or take other action) after using such efforts, would, or would not, nullify the assumption of the liability as between the buyer and the seller in respect of the buyer’s indemnification obligations. The decision also suggests that, where a specific liability is set forth as one that is to be an Assumed Liability, any exclusion of liability relating to the assumed liability should also be addressed specifically in the Excluded Liabilities provision (rather than relying on broad language to exclude any part of a specified Assumed Liability).
    • Waystar: Drafters should keep in mind that the word “and” at the end of a list may not convey clearly whether the list is “joint” (i.e., refers to all of the items listed, together, in the conjunctive sense) versus “several” (i.e., refers to any one or more of the items listed, alone, in the disjunctive sense). Rather than stating that something is applicable “in the event of (x) and (y),” a drafter should consider being more specific—such as, for a “joint” list, specifying: “in the event of both (x) and (y) (with neither alone being sufficient)”; and, for a “several” list, specifying: “in the event of either (x) or (y) or both.”

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