August 23, 2007
Lone Star's Shaky Defense
Earlier this week, Lone Star filed its answer and counter-claims to Accredited Home Lender's lawsuit which seeks to force Lone Star to complete its pending acquisition of AHL. Lone Star bases its counter-claims on two core assertions 1) AHL has breached its representations and warranties and covenants under the merger agreement, and 2) a Material Adverse Effect (as defined in the merger agreement) has occurred or is reasonably likely to occur. Lone Star asserts that these claims entitle it to terminate the merger agreement and limits its liability in the transaction to no more than the reverse termination fee, or $12 million.
More specifically: Lone Star's claim of breach of the merger agreement by AHL is in part premised upon Section 7.01 of the merger agreement which requires AHL “to conduct its business in the ordinary course and [to] use its commercially reasonable efforts to preserve substantially intact the business organization of the Company and to preserve the current relationships of the Company and the Company Subsidiaries . . . .” Lone Star here claims that AHL breached this agreement by failing to take the necessary steps, including slashing employees and overhead, to preserve its sub-prime lending business. Lone Star also asserts a claim that AHL breached Section 8.02 of the merger agreement, which requires AHL to afford Lone Star access to the “books and records of the Company and the Company Subsidiaries, and all other financial, operating and other data and information as [Lone Star] may reasonably request.” Lone Star also alleges that AHL has:
breached its representations, warranties and covenants by, among other things, its (i) acts and omissions that drastically weakened the financial and operating condition of the Company, (ii) acts and omissions that hastened the Company’s descent into a severe liquidity crisis, (iii) acts and omissions that have, or soon will, restrict the Company’s access to the its revolving loans, (iv) violations of covenants in the Company’s core credit facilities, and (v) misstatements regarding and mismanagement of the failing retail loan origination program.
Finally, Lone Star asserts that AHL has suffered a Material Adverse Effect and therefore is in breach of the merger agreement.
As an initial matter, Lone Star's claims surrounding breach of the representations and warranties and covenants look tough to prove, and though Lone Star does well to dress them up, appear to be just a MAC claim in disguise (and, in fact, any breach of a representation or warranty has to be a MAC to justify termination; the breach of covenant does not require that Lone Star prove a MAC, merely a material breach). Nonetheless, to the extent Lone Star is challenging AHL's business decisions, the court is likely to look at the actions of AHL within the context of the business judgment rule and commercial reasonableness. This is a question of fact, but based on the known facts and given the crisis AHL's actions appear reasonable reactions to the sub-prime lending crisis. Moreover, there is a 60 day cure period in the contract for AHL to cure any breaches. Today, AHL announced that it was taking several restructuring initiatives, including terminating 1,000 employees, closing substantially all of the retail lending business and no longer accepting new U.S. loan applications. AHL is likely to claim that these actions, which Lone Star asserts in its counter-claim that AHL had previously failed to take, are such a cure. In fact, I interpret AHL's actions today as a direct response to this claim by Lone Star, though it likely had no other choice from a business perspective given the market situation.
As for the MAC claim, the question boils down to two issues: 1) what did Lone Star know and when did they know it, and 2) is the MAC in Lone Star's business "disproportionate" to the adverse changes in the sub-prime lending business generally. This is important because the definition of MAC in the merger agreement specifically excludes events resulting from any circumstance or condition existing and known to Lone Star as of the date of the merger agreement as well as those that do not disproportionately affect AHL as compared to other companies operating in the industry in which AHL operates.
Here, AHL attempts to prove lack of knowledge by relying on the issuance of a "going concern" qualification by AHL's auditors and the revision in AHL management’s projections from an estimated loss for the third quarter of $64 million to a $230 million loss for the third quarter. It is hard to assess these claims without full information, but my gut reaction is that Lone Star cannot escape the sub-prime implosion, which unfortunately for Lone Star was in full swing at the time of its agreement. I believe that knowledge is likely to be attributed, but this is now a question of fact that will ultimately be decided by Vice Chancellor Lamb. And even if Lone Star can establish that knowledge was absent, it still must prove the MAC to be "disproportional".
Lone Star thus also goes out of its way to prove dis proportionality citing specific lawsuits against the company and other alleged facts to prove that the events occurring at AHL are either specific to AHL or so disproportionate as to be a MAC. Here, Lone Star again cites the disproportionate effect of the implosion of AHL's retail business which AHL shut today. But again, given the mass industry turmoil -- Lehman today shut its sub-prime unit for example -- dis proportionality is going to be hard to prove even in AHL's catastrophic circumstances. Also -- look for the parties to argue over which industry the disproportionality should be measured against; Lone Star is going to argue it is the broader mortgage lending business -- AHL will argue it is the sub-prime business.
Lone Star's claims of a MAC thus appear at this point to be less than solid. Nonetheless, things will reach more clarity as the facts are disclosed at the hearing before VC Lamb. For now, though, two things appear certain. First, given AHL's moves today to shut down its business, purchasing its stock is, more than ever, essentially the purchase of a litigation claim. And whatever the ultimate outcome, VC Lamb will have an important opportunity in this case to clarify Delaware law on MACs and issue an opinion that could have wider consequences for a number of other pending transactions.
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Exerpt from the merger agreement: could you please comment on the word "regardless"
(d) For purposes of this Agreement, “Parent Termination Fee” means $12,000,000 and “Company Termination Fee” means $12,000,000.
(e) Each of Parent and the Buyer Parties acknowledges and agrees that in the event that either Parent or the Company is entitled to receive the Parent Termination Fee or the Company Termination Fee, as applicable, pursuant to this Agreement, the right of such recipient to receive such amount shall constitute such party’s sole and exclusive remedy for, and such amount shall constitute liquidated damages in respect of, any termination of this Agreement regardless of the circumstances giving rise to such termination.
Posted by: Frank | Aug 23, 2007 8:09:43 AM
Thanks for your opinion here. I am but a layman, so your more careful reading of these issues is quite interesting.
I didn't know the 60 day cure angle, but assumed the judge would judge AHL's action in shutting down a good portion of their business as commercially reasonable.
Posted by: Kelley Ritchey | Aug 23, 2007 8:34:18 AM
LEND is currently trading at 5.83. Assume that there are two outcomes:
(1) Shareholders get $15.10
(2) Shareholders get $0 (bankruptcy)
Now solving for x, the market is assigning a 38.61% probability that the deal will get done.
0 * (1 - x) + 15.10 * x = 5.83
Posted by: Wilbur | Aug 28, 2007 10:31:23 AM