On December 29, 2017, the Delaware Chancery Court decided in LSVC Holdings, LLC. v. Vestcom Parent Holdings, Inc. et al. to deny the buyer’s claim for an allocated share of transaction tax deductions (“TTDs”) taken by the seller in a pre-closing tax filing. TTDs include many transactional expenses, such as professional fees and payments for options cancellations or bonuses. Generally, absent contractual modification, pre-closing TTDs benefit the seller, and post-closing TTDs benefit the buyer. As described further below, this case highlights the importance of careful review of transaction documents, as TTDs can dramatically decrease tax obligations for the company eligible to benefit from them.
The buyer in LSVC Holdings argued that the seller violated the terms of the agreement when the seller deducted the entirety of the TTDs on its pre-closing estimated tax filing. The buyer had two main arguments. First, it argued that a tax covenant in the agreement requiring the buyer to pay to the seller 50% of the value of any post-closing refunds or reductions in taxable income arising from TTDs also required the seller to abstain from deducting 50% of TTDs pre-closing (or, alternatively, to pay the benefit of 50% of those TTDs to the buyer) (“tax-benefit splitting covenant”). Second, the buyer argued that the seller violated another covenant requiring the seller to operate the target in the “ordinary course of business” by taking the deductions pre-closing, as a change in control transaction (and, consequently, any TTDs arising from it) is outside of the ordinary course of business. The Chancery Court rejected both of these arguments.
The Chancery Court determined that seller-defendant Vestcom was entitled to include all TTDs in its pre-closing estimated filing in the fourth quarter of the year in which the deal was estimated to close. In reaching its decision, the Chancery Court first concluded that tax-benefit splitting covenant did not create a reciprocal obligation on the seller, because it only included a mandate on the buyer to pay to the seller 50% of tax benefit arising from TTDs, not the converse.
Second, the Chancery Court declined to hold that significant transactions such as changes in control (and deductions of any associated TTDs) are by their nature out of the ordinary course of business. The court pointed out that the logical extension of plaintiff’s argument was absurd, because all actions taken surrounding the acquisition would breach this covenant under plaintiff’s theory. Instead, the Chancery Court looked to the seller’s past practice, and concluded that the deduction of the TTDs pre-closing is perfectly consistent with the seller’s other tax filing practices and therefore complied with this covenant. It also emphasized that the resulting overpayment of $6 million to the IRS if the seller, Vestcom, did not deduct the TTDs would be highly out of “the ordinary course of business.” The court was particularly convinced by the seller’s CFO, who the court found testified with a “noteworthy degree of candor to the court” that the approach to the TTDs was consistent with the company’s past practice.
This decision highlights the importance of carefully negotiated and drafted provisions in M&A agreements related to the allocation of TTDs (and other tax benefits). Particularly, this case underscores the need to understand the interplay of complex tax provisions in the agreement, ensure that those provisions reflect the intent of both parties, and communicate effectively between counsel and the transaction parties during the course of negotiations. In the instant case, due to a failure of communication, it is possible that the individuals who negotiated the letter of intent had different understandings of the meaning of the tax-benefit splitting covenant. Earlier involvement of counsel and a more focused concentration on understanding and accurately expressing the intent of the parties could have prevented this dispute.
However, even if both parties had agreed on and understood the intended meaning of the tax-benefit splitting covenant, negotiations and drafts exchanged between counsel can override that understanding. In reaching its conclusion, the Chancery Court reviewed not only the agreement, but also the course of negotiations, and expert evidence about standard business practice regarding TTDs. In this case, the negotiation of the drafts by the attorneys may have contradicted prior principal-to-principal discussions, resulting in a material change in the meaning of the tax-benefit splitting covenant. Despite the possibility that the draft reflected an inaccurate understanding of the parties’ intent, the court held that the parties were bound by their agents and the ultimate contract.