Important Lessons from the Court of Chancery Regarding PE Sponsors, Portco Operating Agreements, Failed Projections, and More—P3 Health Group
M&A/PE Briefing | November 3, 2022
In re P3 Health Group involves a challenge to the de-SPAC merger of P3 Health Group Holdings, LLC (the “Company”), a Delaware limited liability company that is a portfolio company of private equity sponsor Chicago Pacific Founders Fund, L.P. Chicago Pacific controlled the Company through its majority equity ownership, board designees, and contractual rights. The plaintiff, private equity firm Hudson Vegas Investments SVP LLC, was the Company’s second-largest unitholder. In a series of recent decisions, the Delaware Court of Chancery held, at the pleading stage of litigation, as follows:
- A Chicago Pacific principal faces potential liability with respect to the merger—because, based on the allegedly significant role he played as part of the Chicago Pacific team that engineered the merger, he was an “acting manager” of the Company, even though he had no formal role at (i.e., was not a named manager, nor a director, officer or employee of) the Company. (This decision was issued Oct. 26, 2022.)
- The Company’s General Counsel faces potential liability with respect to the merger—because, based solely on her title, she was an “acting manager” of the Company, although she had asserted that despite her title her actual role had been merely “ministerial.” (This decision was issued Sept. 12, 2022.)
- The Company faces potential liability for alleged breaches of its contractual obligations to Hudson—because (i) effecting the merger without Hudson’s consent may have violated Hudson’s right under the Company’s LLC operating agreement to veto affiliated transactions, given that (a) after the merger, Chicago Pacific designated members of the surviving company’s board and (b) Chicago Pacific contemplated a follow-on transaction involving another of its portcos; and (ii) the distribution to Hudson may not have fulfilled Hudson’s priority distribution right, given that the Company deemed the fair market value of the distributed SPAC shares to be the nominal $10 per share when the actual value likely was significantly less. (This decision was issued Oct. 31, 2022.)
- Chicago Pacific and the Company (and their key managers) face potential liability for alleged fraudulent inducement of Hudson’s initial investment in the Company—because the near-term Company projections provided to Hudson at that time were significantly higher than the actual results turned out to be, under circumstances that supported a reasonable inference of fraud based on the Company’s small size and the large spread between the projected and actual results. (This decision was issued Oct. 28, 2022.)
- In our view, it was the combination (rather than any one of) the actions taken by Chicago Pacific’s principal in connection with the merger that led to the court’s conclusion that he was an “acting manager” of the Company and thus faced potential liability with respect to the merger. The court emphasized in particular that he left the Company’s board “in the dark” about the merger as it progressed; “instructed” and “directed” the Company’s management and outside advisors; had access to information that the Company’s board and management did not have; and insisted to the Company’s legal counsel (in an email) that he and Chicago Pacific were “in charge.”
- Officers of Delaware LLCs should anticipate expanded potential for liability in connection with their roles. While the Court of Chancery previously had interpreted the Delaware LLC Act to confer personal jurisdiction over any person with the title of “President” of a Delaware LLC, in this case, expanding that interpretation, it held that the Act confers personal jurisdiction over any person with “a senior role” in a Delaware LLC who performs functions consistent with that role. The court also held that whether the Company’s general counsel performed functions consistent with her title was a fact-intensive issue that could not be determined at the pleading stage (at which the standard to survive a motion to dismiss is low).
- A sponsor’s post-merger designation of directors to the board of the surviving company of a merger with its portco may violate a portco investor’s affiliated transactions consent right. The court found, based on the (relatively standard) language of the consent right provision in the Company’s LLC operating agreement, that the Company’s post-merger designation of Chicago Pacific principals to the surviving company’s board may have breached Hudson’s affiliated transactions consent right. The decision underscores the broad interpretive effect from use of the phrases “series of related transactions” and “entry into an agreement” in a provision granting an affiliated transactions consent right.
- In the context of a de-SPAC merger, a company may breach its obligation to provide a “priority distribution” to an investor under the contractual waterfall provisions if the company deems the fair market value of the SPAC shares that are distributed to be their nominal value of $10 per share and the actual value is lower. The court pointed to academic work demonstrating that the value of SPAC shares when a de-SPAC merger takes place generally is “materially less” than the nominal $10 per share value. Moreover, in this case, the actual closing price of the SPAC’s shares just two days before the merger was $8.87 per share.
- While a failure of projections to pan out generally is not actionable, in this case the court found, based on the circumstances, that it supported an inference of fraud at the pleading stage. The court found an inference of fraud reasonable here because, at the time the projections were given to Hudson when it was considering whether to invest in the Company, the Company was closely-held and small (which indicated that accurate near-term projections should have been possible) and the swing between the projections and the actual results was very large (representing “a dramatic reversal from a positive projection to a large loss”).
Background. Chicago Pacific provided the start-up capital for the Company and, from the outset, was the Company’s controller based on its majority equity ownership, five board designees (on an eleven-person board), and contractual rights. In November 2019, Hudson invested $50 million in the Company, becoming the second-largest unitholder and obtaining two board seats. In 2020, the Company considered how to go public. It was decided that the Company would engage in a de-SPAC merger with Foresight Acquisition Corp. (a SPAC formed by an unaffiliated businessperson). The transaction initially was structured as a three-way merger that included another Chicago Pacific portfolio company known as “MyCare.” Hudson, which had a contractual right to veto affiliated transactions, objected to the transaction as it would strip Hudson of $100 million of stock options and its other contractual rights with respect to the Company. Chicago Pacific and the Company restructured the merger to exclude MyCare and proceeded without Hudson’s consent. Allegedly, they contemplated a later, follow-on transaction to merge in MyCare.
In September 2021, Hudson unsuccessfully sued to enjoin the merger. Following closing of the merger in December 2021, Hudson amended its complaint to assert claims against Chicago Pacific and certain of its and the Company’s directors and key managers for having tortiously interfered with Hudson’s contractual rights by arranging for the merger. Hudson also added claims that the defendants had “fraudulently induced” it to make its initial investment in the Company. In a series of decisions, Vice Chancellor Laster rejected dismissal of these claims.
Delaware has jurisdiction over persons who are not formally named as “managers” but who act as de facto managers of a Delaware LLC. Section 18-109(a) of the LLC Act provides that service of process can be served on (i) any person who is formally named in the LLC’s governing documents as a “manager” (a “formal manager”) or (ii) any person who “participated materially in the management” of the LLC (an “acting manager”). When the court previously has held that a person was an “acting manager,” the person typically had some formal role as an officer or employee of the LLC. However, a formal role at the LLC is not necessary for a finding that a person was an “acting manager.” Rather, the concept of an “acting manager” refers to “a person who acts on behalf of the LLC, either generally or for the purpose of a specific transaction, by making decisions for or taking action on behalf of the LLC.” In P3 Health, the court noted that this is essentially the same standard as is required to impose liability on an acting manager for actions taken by the LLC.
The court deemed SM to be an “acting manager” with respect to the merger based on his role in arranging the transaction. We would observe that sponsors and their principals without official roles at a portco, in connection with their monitoring the portcos and seeking to facilitate their success, often engage in the kinds of activities in which SM allegedly engaged in connection with the merger—such as attending meetings about strategic alternatives, reviewing documents and agreements, helping to address funding issues, assisting with tax structuring, and so on. What distinguishes P3 Health, in our view, is the combination of these various activities together with (i) SM’s having “instructed” and “directed” the Company’s formal managers and outside advisors (including insisting that legal counsel not distribute any draft agreements without a prior sign-off from SM or Chicago Pacific), (ii) SM’s having stated in an email to the Company’s legal counsel that he and Chicago Pacific were “in charge” of the Company, (iii) SM and Chicago Pacific having more information than the board and keeping the board “in the dark”; and (iv) the overall negative factual context of the case (as discussed below). The court emphasized that SM and Chicago Pacific “made decisions on behalf of the Company”; “directed the Company’s management to take action”; “instructed the Company’s advisors to perform work without authorization from Company management”; “berated the Company’s outside counsel for not running documents by him before sending them out”; and “enjoyed access to information that even formal managers of the Company did not have.”
The court deemed the Company’s General Counsel to be an “acting manager” based on her title. The General Counsel contended that she had not “materially participated” in the management of the company, and thus was not an “acting manager,” because, notwithstanding her title, her role actually had been only “ministerial” (both generally and with respect to the merger). Vice Chancellor Laster acknowledged that in past cases the court found that the “material participation” standard in the LLC Act applies to persons who hold the title of “president” of an LLC and perform functions customarily associated with that role. However, the Vice Chancellor focused on the “plain meaning” of “participates materially,” as well as the “natural habitat” of those words in other statutes (such as the federal tax code and the DGCL’s consent-to-jurisdiction statute for corporate officers). Based on that analysis, the Vice Chancellor expanded the interpretation of the jurisdiction provision to cover not just a “president” of a Delaware LLC but any person with “a senior role” (such as the equivalent of a corporate “C-suite” role) who performs functions customarily associated with that role. Whether the Company’s General Counsel performed functions consistent with the role of a general counsel was an issue that the Vice Chancellor concluded could not be determined at the pleading stage. The Vice Chancellor also found that it was reasonable to infer that the General Counsel actually had “materially participated” in events with respect to the merger. For example, “she provided advice to the Board, and she reviewed and assisted in the preparation of material for the Board. She was responsible for documenting the actions that the Board took by preparing and circulating minutes for the Board’s meetings. She also assisted in preparing and commenting on the disclosures that the Company provided to its investors in connection with the transaction.” When Hudson objected to the merger, “she worked with…the Company’s outside counsel on a response to Hudson’s concerns”; “instructed” the outside counsel to remove certain language in the draft response; and sought advice from the Company’s outside counsel as to how to minimize the provision of information to Hudson’s board representatives.
The court found that the Company may have breached Hudson’s right to consent to affiliated transactions—by (i) its post-merger designation of Chicago Pacific principals to the surviving company’s board and (ii) its continued focus on ultimately merging in MyCare. First, the court considered that Chicago Pacific designated three of its principals to the board of the surviving company in the merger and that those principals would receive director compensation. The Company argued that the directorships and compensation were received from Foresight (not the Company), after the merger had closed and the Company’s existence had terminated—thus, the consent provision, it argued, no longer existed and there was no one who could enforce it. The court disagreed, noting that the affiliated transactions consent right (a) applied not only to the merger itself but also to any “series of transactions” having the same effect,” and (b) covered “entering into any agreement” involving an affiliated transaction. With respect to (a), the court wrote that, “[g]iven that broad language, it [was] [(at the pleading stage)] reasonably conceivable that a transaction or series of transactions in which principals of Chicago Pacific ultimately receive[d] compensation arrangements could require Hudson’s consent.” Indeed, the court observed, Chicago Pacific’s “extract[ing] a non-ratable benefit for its principals…[was] precisely the type of transaction that the Affiliated Transactions Consent Provision allow[ed] Hudson to prevent”—and the fact that the benefit “came after the deal closed and from the surviving entity [did] not give Chicago Pacific a free pass.” With respect to (b), the court stated that it was reasonably conceivable that a breach occurred when the merger agreement was executed (that is, before the merger occurred and the company’s existence was terminated)—therefore, the merger could not have extinguished such a claim.
Second, the merger may have violated the consent right in that, allegedly, Chicago Pacific “remained committed” to including MyCare in the merger as a follow-on transaction in the future. Hudson pointed to Chicago Pacific having “continued working on that concept” for a month after Hudson withheld its consent to the merger as initially structured. Hudson also argued , and the court agreed, that the only rational reason for Chicago Pacific to have remained committed to a deal with Foresight might be that Foresight had agreed to the follow-on merger with MyCare—given that Foresight had demanded “onerous terms,” Foresight had reduced its valuation of the company by a third, the size of the PIPE financing had “plummeted,” Foresight had experienced “massive redemption requests,” and the Company’s financial advisor had advised that the Company should negotiate with other sponsors to create competition.
The Company may have breached Hudson’s rights under the waterfall distribution provisions—by valuing the SPAC shares that were distributed at their nominal value of $10 per share. Under the waterfall distribution provisions in the operating agreement, Hudson was entitled to a $50 million priority distribution in the merger. The court agreed with Hudson that Hudson may not have received the full amount of the priority distribution, given that the SPAC shares distributed, which were to be valued at fair market value, were valued at $10 per share, while just two days before the merger the closing share price per share was $8.87. The court noted that scholars “have explained persuasively that the value of SPAC equity when a de-SPAC merger takes place is materially less than $10 per share.” The court cited an academic study reporting that the mean and median SPACs in the cohort reviewed had just $4.10 and $5.70, respectively, in net cash per share outstanding at the time of their merger.”
The court found that Chicago Pacific and the Company may have fraudulently induced Hudson to make its initial investment in the Company. As alleged by Hudson, when it was deciding whether to invest in the Company, Chicago Pacific and the Company’s two co-founders (who were directors and senior officers of the Company) and their representatives provided Hudson with projections reflecting 2020 EBITDA for the Company “north of $12.7 million.” When Hudson received the Company’s actual 2020 results, EBITDA was “negative $40 million.” Hudson contended, and the court agreed, that, as the Company at that time “was a closely-held, relatively small LLC” (with $14.5 million in assets and 52 full-time employees), the defendants likely would “have had a precise sense of [the Company’s] business and financials.” The court wrote that the projection “did not involve puffery about the business, nor was it a projection about the firm’s performance stretching across multiple years into the future.” The court acknowledged that “the fact that a projection does not come to fruition, standing alone,” often is insufficient to state a cognizable claim for misrepresentation, but, it stated, the court can consider “whether a sizeable miss on a near-term projection” indicates that the projection was “knowingly false.”
The court found that the agreement pursuant to which Hudson acquired its interest in the Company did not foreclose Hudson from suing the defendants for fraud. The agreement contained a “no-representations” and “no-reliance” provision (stating that the only representations being made and on which Hudson could rely were those expressly set forth in the agreement)—however, that provision was qualified by a “fraud carve-out” (stating that claims arising from fraud or intentional misrepresentation were not subject to the no-representation/no-reliance provision). More significantly, the court acknowledged that the “no-recourse” provision in the agreement specified that only a party to the agreement could be sued, and that the plain language of the provision supported the defendants’ contention that Hudson was precluded from suing the defendants. However, the court held, as has long been established, that “Delaware public policy will not permit parties to use a no-recourse provision to insulate themselves from fraud.”
We note the seemingly negative overall factual context of the case. We would emphasize that, as discussed, Hudson’s pleadings, which the court found were “bolstered by contemporaneous documents,” included that: the merger was restructured to avoid Hudson’s veto right (with the defendants envisioning that they would accomplish the affiliated-transaction piece later); the Company ignored its financial advisor’s advice to negotiate with other bidders to create competition in the process; the acquiror, mid-transaction, lowered its valuation of the Company from $3.3 billion to about $1 billion; Chicago Pacific and the Company’s officers “moved forward at the lower valuation without discussing it with the full Board,” and “[t]o grease the skids,” the SPAC founder gave two Chicago Pacific principals “the lucrative opportunity” to participate in another of his SPACs; after Hudson objected to the merger, the Company’s board was “left in the dark” about the transaction, including with respect to material developments such as a decision to proceed with the transaction even after the SPAC market declined and the anticipated proceeds from the PIPE financing dropped significantly; the merger was structured to permit Chicago Pacific (but no other Company member) to receive part of the merger consideration directly from Foresight in a non-taxable exchange (although the court held that this was not an actionable claim); and Hudson’s initial investment in the Company was based on allegedly fraudulent information provided by the Company and Chicago Pacific.
- Observing corporate formalities with respect to portcos. Broadly speaking, decisions for a portco typically should be made by the portco’s board and management. As a general matter, sponsors’ influence is best exercised through its equity ownership, board designees, and/or contractual rights. In this case, the sponsor principal’s articulating that he and the sponsor were “in charge” appeared to be a key factor in the court’s result.
- Increased risk for potential liability of portco officers. In light of the court’s expanded interpretation of the consent-to-jurisdiction provision of the LLC Act, portcos and sponsors should review their exculpation, indemnification and advancement provisions and their D&O insurance coverage to ensure that they operate to provide appropriate protections. We note that the interplay among these sponsor and portco provisions and policies often is complex.
- Emails, emails, emails. As so many Delaware cases highlight, and as we so often caution, directors, officers, controllers and others must exercise care with respect to their use of emails and other informal communications, as these often are used (and often prove to be critical) in litigation, particularly as evidence of intent or fraud, which otherwise may be difficult to prove.
- Drafting affiliated transaction consent rights. Given the court’s discussion in P3 Health, consideration should be given to specifying in a portco’s operating agreement whether the post-merger designation of directors to a surviving company’s board would, or would not, constitute an affiliated transaction as to which a consent right would apply.
- Drafting waterfall distribution provisions. Given the court’s discussion in P3 Health, consideration should be given to providing greater specificity in waterfall provisions as to the value to be ascribed to SPAC shares that are distributed.
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