On May 29, 2019 in Shareholder Representative Services, LLC v. RSI Holdco, LLC,[1] the Delaware Court of Chancery, by giving effect to a merger agreement provision, reemphasized the guidance it gave in Great Hill Equity Partners IV, LP v. SIG Growth Equity Fund I, LLLP[2] that a seller in a private-company merger may use its “contractual freedom” to retain the attorney-client privilege for pre-closing communications by including explicit language to that effect in the merger agreement.[3] Absent such language, the privileged communications would have otherwise been transferred to the surviving entity pursuant to Section 259 of the Delaware General Corporation Law (the “DGCL”).  The decision relied upon a carve-out provision that Radixx Solutions International, Inc. (the “Seller”) negotiated in its merger agreement (the “Merger Agreement”) with RSI Holdco, LLC (the “Buyer”).

The effectiveness of the carve-out provision was called into question when, in post-closing litigation, the Buyer attempted to use approximately 1,200 emails stored on the target company’s servers against the Seller. The emails were sent pre-merger between the Seller and its counsel. The Buyer argued that by failing to excise or segregate the communications from the servers the Seller waived the privilege. Following its precedent in Great Hill, the Court disagreed.

In Great Hill a seller’s attempts to claim attorney-client privilege for pre-merger communications failed, largely because “the merger agreement lacked any provision excluding pre-merger attorney-client communications from the assets of [the seller] that were transferred to the [b]uyer as a matter of law in the merger . . . .” The seller in Great Hill based its claim on an assumption that § 259 of the DGCL should be interpreted to make a carve-out provision unnecessary.  The seller contended that the transferring of “privileges” referred to in § 259 should be interpreted to exclude the attorney-client privilege. This reading would mirror the rule governing mergers in New York, which underscores the importance of maintaining attorney-client privilege protections.[4] The court in Great Hill declined to adopt this interpretation, but emphasized that the seller’s objectives could have easily been met had they negotiated for a protective provision that carved out such communications from the transferred assets.

The Court in RSI Holdco relied on this reasoning in its rejection of the Buyer’s argument that the Merger Agreement’s carve-out provision did not provide immunity from waiver of privilege. In analyzing the carve-out provision in question, the Court noted that the provision achieved four objectives: (1) it indefinitely preserved any pre-merger attorney-client ‎privilege resulting from communication between the Seller’s counsel and the Seller relating to the merger; ‎‎(2) it assigned control of the privilege to the Seller’s representative; (3) it made both parties ‎responsible for ensuring that the privilege remain in effect; and (4) it prohibited the Buyer from ‎using or relying on the privileged information in a post-closing action or claim involving the two ‎parties. ‎The Court reasoned that it would be illogical and counter to the holding in Great Hill to conclude that privilege can be waived through failure to affirmatively protect privileged information, noting that the Merger Agreement’s carve-out provision expressly provided for both parties to ensure that the privilege remain in effect.

The Court’s decision is a reminder of the importance of carve-out provisions in private-company merger agreements governed by Delaware law and a confirmation of the effectiveness of such a provision, as suggested in Great Hill.

The following are a few practice points arising from RSI Holding. First, a carve-out provision must be included in the merger agreement governed by Delaware law if a seller wishes to retain the attorney-client privilege for pre-closing communications. Second, the language must unambiguously encompass the privileged communications to be protected so that there is no debate as to exactly what is carved-out from the transfer. Third, an express covenant that the buyer will not use the privileged information in any lawsuit involving the seller will help negate any claim of waiver of privilege. Last, while unnecessary in RSI Holdco, it remains best practice for sellers to excise pre-merger communications from their computer systems prior to closing. Employing these practice points should help reduce the risk of an unintended transfer of the attorney-client privilege in a merger transaction under Delaware law.

[1] C.A. No. 2018-0517-KSJM (Del. Ch. May 29, 2019).

[2] 80 A.3d 155 (Del. Ch. 2013).

[3] The rule in Great Hill and RSI Holdco does not apply to asset purchases because privileges are not automatically transferred in that context.

[4] Under the New York rule, stated in Tekni-Plex, Inc. v. Meyner & Landis, 80 N.Y.2d 123 (N.Y. 1996), the seller’s attorney-client privilege relating to deal negotiations remains with the seller after the closing of the transaction.