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Mercury Systems, Inc. v. Shareholder Representative Services, LLC

United States Court of Appeals, First Circuit

April 26, 2016

MERCURY SYSTEMS, INC., Plaintiff, Appellant,


Christopher H.M. Carter, with whom Hinckley, Allen & Snyder LLP was on brief, for appellant.

Roger A. Lane, with whom Courtney Worcester and Foley & Lardner LLP were on brief, for appellee.

Before Thompson, Lipez, and Barron, Circuit Judges.


We must interpret a merger agreement in which one party agreed to indemnify the other against a purely hypothetical tax loss. The sellers agreed to indemnify the buyer for the tax liabilities of the company being sold, except that the tax bills for indemnification purposes were to be calculated as if certain deductions would not be taken, when both parties knew they would be. Given that these deductions, perhaps in combination with other deductions, reduced the company's tax liability to zero, the company's tax prepayments and credits were refunded in their entirety, benefitting the buyer as the company's new owner. Yet, because the calculation of the indemnity obligation was based on a counterfactual measure of tax liability, that calculation resulted in the sellers' nonetheless owing the buyer a substantial amount of money. The issue that divides the parties is whether the prepayments and credits, and resulting tax refunds, affect the tax indemnification obligation of the sellers.

The district court concluded that the indemnification provision, by its terms, unambiguously required that the indemnity obligation be offset by the amount of the refunded prepayments and credits. It therefore entered judgment on the pleadings in favor of the seller.

We conclude that the indemnification provision is ambiguous as to how the tax refunds affect the indemnification obligation of the sellers. Though these sophisticated parties knew of the tax prepayments and credits, and expected substantial tax refunds, they failed to specify how those refunds should be treated. This critical omission renders their contract ambiguous on the issue before us. The plain language arguments of the parties are not fully convincing; reasonable interpretations of the text support both positions. Their arguments about the purpose and negotiating history of the provision cannot be resolved without the aid of a fact-finder. Indeed, the parties dispute key facts about the company's tax refunds. Hence, we vacate the judgment of the district court and remand for further proceedings.


A. Background

The indemnity provision at issue is part of a 2011 merger agreement by which Mercury Systems, Inc.[1] ("Mercury") purchased KOR Electronics ("KOR") from KOR's stockholders and optionholders ("securityholders, " represented on appeal by Shareholder Representative Services, Inc., "SRS"). Consistent with the terms of the agreement, Mercury created a merger subsidiary (King Merger Inc.) and merged it with and into KOR, which thus became a wholly-owned subsidiary of Mercury.

Mercury agreed to pay KOR's securityholders $70 million for the company, with adjustments for, inter alia, merger-related expenses and the amount of cash and debt on KOR's books as of the closing date. Merger Agreement ["MA"] § 3.02. These adjustments would be based on a balance sheet reflecting estimates of KOR's 2011 assets and liabilities, which KOR promised to provide. MA § 3.05(a). Of the purchase amount of $70 million, $10.65 million would be paid into an escrow account to cover various obligations of the securityholders. MA § 3.03(b).

The indemnity arrangement relevant to this appeal is set forth in detail in Article X, section 10.02(a), and referenced in sections 10.01 and 10.05(a) and (b). Section 10.02(a) provides that SRS will prepare KOR's 2011 federal and state tax returns. Then, SRS, on behalf of the former securityholders, must release money from the escrow account to pay Mercury "the amount of the aggregate Tax liabilities due, if any." App. 31-32.[2] The unusual feature of the arrangement is how the obligation to pay Mercury was to be measured. When preparing KOR's 2011 tax returns, SRS was required to claim two types of merger-related expenses as tax deductions. This requirement is stated in section 10.02(a) and echoed in sections 10.05(a) and (b). App. 41-42 (requiring SRS to "giv[e] effect to any deductions described in Section 10.[0]5"); id. at 54-55 (specifying that the merger-related deductions "shall be claimed"); id. 61-62 (same). However, the securityholders' obligation to pay Mercury was to be calculated without claiming those deductions. MA § 10.02(a). The arrangement is set forth as follows:

[F]or purposes of determining the Tax liability due with respect to such Tax Return for purposes of calculating the Securityholders' indemnification obligations, the determination of the Tax liability for any such Pre-Closing Tax Period will be calculated and determined excluding any deductions described in Section 10.05 below. The amounts actually due on the Tax Return (after giving effect to any deductions described in Section 10.[0]5[3]below) shall promptly be paid by [Mercury] to the appropriate Governmental Authority.

Id. (App. 34-46) (emphasis in original). In other words, Mercury would receive, in payment of the indemnity obligation, an amount from escrow equal to KOR's tax liabilities as calculated without the deductions, but pay KOR's actual taxes (if any were still owed) computed with the deductions. Because KOR was required to claim the section 10.05 deductions on its 2011 tax return, the calculation of taxes without those deductions was necessarily greater than KOR's actual taxes owed. SRS conceded in the district court that this arrangement could require it to pay Mercury for "a phantom 'liability' for indemnification purposes that is not actually due to the government."

Section 10.02(a) creates an obligation specific to one tax year, the year to which the merger-related tax deductions apply: 2011. Further, by its terms, section 10.02(a) applies only to taxes related to returns "due after the Closing Date." App. 25. The parties identify no tax period, other than 2011, for which returns had yet to be filed as of December 30, 2011. This obligation -- specific to 2011 -- is distinct from the conventional tax indemnification provision in section 10.01, which applies more generally to all pre-closing time periods:

[E]ach Securityholder shall . . . indemnify and hold harmless [Mercury] from, against and in respect of any and all Losses[4] that constitute or that result from, arise out of or relate to, directly or indirectly [] Taxes (or the non-payment thereof) of [KOR] for all Pre-Closing Tax Periods . . . .[5]

MA § 10.01 (App. 6-11.). Section 10.01 clarifies, however, that this general tax indemnification provision does not override the specific arrangement for 2011:

Notwithstanding any other provision of this Agreement, the determination of the Taxes with respect to this Section 10.01 will be calculated without taking into account any deductions described in Section 10.05 below.

MA ยง 10.01 (App. 12-15). In other words, section 10.01 recognizes that the former securityholders are required to indemnify Mercury for more than its actual tax losses ...

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