In Consolidated Edison, Inc. v. Northeast Utilities, the U.S. Court of Appeals for the Second Circuit recently held that stockholders of Northeast Utilities (NU), the target company in a failed merger, have no right as third-party beneficiaries to sue Consolidated Edison, Inc. (CEI), the acquiring company, for lost premium damages. The case arose out of a failed billion-dollar merger between CEI and NU entered into on October 13, 1999.
Under the original agreement, CEI was to pay $3.6 billion for the outstanding shares of NU, a premium of 40 percent over the then trading price of NU shares. This premium constituted approximately $1.2 billion of the total purchase price. On March 5, 2001, CEI declined to proceed with the merger, alleging NU had suffered a material adverse change. Thereafter, NU brought suit on behalf of its stockholders for the loss of the acquisition premium in the merger agreement. The District Court for the Southern District of New York ruled that NU could sue on behalf of its stockholders because the merger agreement designated such stockholders as third-party beneficiaries.
As a general matter, the intent of the contracting parties as reflected in the language of the agreement determines whether third-party beneficiary status is intended by the parties. In private and public company merger agreements alike, third-party beneficiary status is typically granted to stockholders and certain others (e.g., directors, officers and employees of the target company) in respect of certain provisions of the agreement. After control of the target transfers to the acquiror, the target cannot effectively enforce the rights of such persons following the consummation of the merger.
In 2005, on interlocutory appeal from the district court, the Second Circuit addressed the issue of whether any NU stockholders possessed the right as third-party beneficiaries to sue CEI for lost premium damages. The Second Circuit held that no stockholder, or NU acting on behalf of its stockholders, could enforce CEI’s promise to complete the merger. The Second Circuit took a strict constructionist view of the language of the merger agreement and opined that since the merger was never completed, "that right never arose."
The Second Circuit, citing well-established precedents, held that to create a third-party right to enforce a contract "the language of the contract must clearly evidence an intent to permit enforcement by the third party." Absent such clear language, New York courts have been disinclined to interpret such an intent. In this case, the court held that third-party rights of NU stockholders were limited to collecting the premium only upon the consummation of the merger, and the parties did not intend to grant NU stockholders the right to sue to compel completion of the merger or for damages resulting from a failed merger.
The Second Circuit relied heavily on the precise language of the merger agreement. Although the court’s interpretation may control future decisions on this matter, potential acquirors may choose to clarify that third-party beneficiary status granted to stockholders and others only vests upon consummation of the transaction. In these circumstances, target stockholders would appear to be relegated to asserting any claims against an acquiror in a failed transaction derivatively on behalf of the target company—a procedure that has significant drawbacks.