Delaware Supreme Court Decision Highlights Interpretation of "Commercially Reasonable Efforts" and "Reasonable Best Efforts"
The Delaware Supreme Court (the Court) recently affirmed the lower court’s decision in a case involving an alleged breach of a merger agreement with respect to a purchaser’s obligation to use “commercially reasonable efforts” to obtain a tax opinion and to use “reasonable best efforts” to consummate the transaction. While the Court affirmed the Chancery Court’s decision in favor of the purchaser (the defendant), the Court employed different reasoning and critiqued several aspects of the Chancery Court’s analysis. Importantly, the majority opinion determined that the terms “commercially reasonable efforts” and “reasonable best efforts” may impose affirmative obligations on parties to take all reasonable steps toward closing a transaction and that acting in good faith may not be enough to satisfy such a standard.
The Williams Companies, Inc. v. Energy Transfer Equity, L.P. involved a merger agreement (the Agreement) between two energy companies, Energy Transfer Equity, L.P. (ETE) and The Williams Companies, Inc. (Williams). The merger was structured in a two-step process for tax purposes: (1) Williams would merge into Energy Transfer Corp LP (a new entity); and (2) Energy Transfer Corp LP would transfer the Williams assets to ETE in exchange for newly issued Class E partnership units. The merger was conditioned upon the issuance of an opinion of ETE’s tax counsel, Latham & Watkins LLP, that the second step “should” be a tax-free exchange of a partnership interest for assets under Section 721(a) of the Internal Revenue Code (the Opinion). The Agreement contained covenants requiring the parties to use “commercially reasonable efforts” to obtain the Opinion and “reasonable best efforts” to consummate the transaction.
After the parties executed the Agreement, the energy market suffered a severe decline, and the transaction became financially undesirable to ETE. ETE raised the issue that the IRS may view a portion of the cash consideration as payment not only for Energy Transfer Corp LP stock (now of diminished value) but also in part for the Williams assets, rendering the transaction taxable. In light of this concern, Latham & Watkins was unwilling to issue the Opinion, and ETE declined to proceed with the merger. In response, Williams sought to enjoin ETE from terminating the Agreement, arguing that ETE breached the Agreement by failing to use “commercially reasonable efforts” to obtain the Opinion and “reasonable best efforts” to consummate the transaction. The Chancery Court rejected Williams’ arguments, holding that ETE did not breach its covenants, and declined to enjoin ETE from terminating the Agreement.
The Court’s Analysis
The Delaware Supreme Court ultimately affirmed the Chancery Court’s decision, but based largely on different reasoning, highlighting several noteworthy errors in the Chancery Court’s analysis along the way.
The Chancery Court had relied on a discussion of “reasonable best efforts” set forth in Hexion Specialty Chemicals, Inc. v. Huntsman Corporation, finding that “reasonable best efforts” meant good faith and that “reasonable best efforts” was similar to “commercially reasonable efforts.” Based on this interpretation, the Chancery Court determined that ETE was bound to do those things objectively reasonable to produce the Opinion. The Chancery Court noted that, unlike in Hexion where the company knowingly fed its advisor inaccurate information to receive an opinion allowing it to avoid a merger, the record in this case did not reflect any affirmative acts taken by ETE to mislead ETE’s tax counsel and prevent the issuance of the Opinion. In other words, tax counsel’s determination that it could not issue the Opinion was a good faith determination made independent of any conduct by ETE.
The Supreme Court, however, took a broader view and stated that Hexion recognized that covenants like those in the Agreement impose affirmative obligations to take all reasonable steps to solve any problems (e.g. obtaining a required tax opinion) and otherwise consummate the transaction. The Court found that the Chancery Court had erred by focusing only on the absence of evidence showing ETE obstructed the issuance of the Opinion. Nevertheless, the Court still determined that there was sufficient evidence on the record from which the Chancery Court could have concluded that ETE failed to fulfill its affirmative obligations (and thus breached its covenants) and that the Chancery Court had properly concluded that ETE had met its burden of proving that any alleged breach of its covenants did not materially contribute to the failure of the Opinion closing condition and the overall transaction.
Chief Justice’s Dissent
The most notable part of this decision may be the lengthy dissent by Chief Justice Strine in which he focused on the fact that in affirming the Chancery Court’s decision, the majority had not viewed the case through the “appropriate lens.” Chief Justice Strine opined that commercially reasonable efforts is a comparatively strong commitment, one that is only slightly more limited than best efforts. He believed the majority had focused on the wrong issue: whether ETE’s tax counsel was honest when he said he could not give the Opinion, rather than determining whether ETE had used commercially reasonable efforts to obtain the Opinion. The question of why the tax counsel did not give the Opinion was of central importance to this determination yet was not fully explored by the majority. The majority was simply satisfied with its determination that ETE had not coerced or misled its tax counsel to prevent the issuance of the Opinion. The Chief Justice also raised doubts as to ETE’s claim that it did not know of the potential tax issue until after the Agreement had been executed. The dissent also asserted that ETE had kept the other side of the transaction in the dark for a commercially unreasonable and suspiciously long period of time.
The dissent further emphasized that the Chancery Court’s assertion that the case would have come out the same way regardless of whether the burden of proof had been properly placed on ETE was not an acceptable substitution for a proper analysis. In light of the problematic nature of the majority opinion, the Chief Justice stated that he would remand and require a new trial at which ETE would be required to prove that its breach did not materially contribute to the failure of its tax counsel to deliver the Opinion.
Business lawyers and others drafting commercial contracts often use the terms “commercially reasonable efforts," “reasonable efforts," “reasonable best efforts” and other variations (often using differing terms within the same contract) without precision as to the intended scope of the obligation that is being imposed by each term. These terms are sometimes used interchangeably without much thought being given other than that “best efforts” is a more strenuous standard than “reasonable efforts.” The Williams decision highlights the importance of precision in drafting and suggests that parties should consider defining these terms within a contract to illustrate the scope or types of effort that are expected to satisfy the applicable condition. We often see contracts that will expressly limit the type of efforts required (e.g. no significant out of pocket expense required), but more thought should be given to what affirmative obligations are being imposed.
If you have questions or would like additional information, please contact Lori Smith (firstname.lastname@example.org; 212.714.3075), Bridget Henwood (email@example.com; 212.631.4421), Michael Psathas (firstname.lastname@example.org; 212.868.4833) or another member of our Corporate and Securities Group.
 The mechanics of the first step were as follows: ETE would transfer $6.05 billion in cash to Energy Transfer Corp LP in exchange for 19% of Energy Transfer Corp LP’s stock. Then, the $6.05 billion and 81% of Energy Transfer Corp LP’s stock would be distributed to the Williams stockholders in exchange for their Williams stock.