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Friday, September 28, 2007

Mistakes M&A Lawyers Make (A Continuing Series)

On Wednesday Fremont General Corporation, the savings and loan and former sub-prime mortgage lender, announced that it has been advised by Mr. Gerald J. Ford that "he is not prepared to consummate the transactions contemplated by the Investment Agreement entered into on May 21, 2007 among the Company, FIL and an entity controlled by Mr. Ford on the terms set forth in that agreement."  The Investment Agreement provides for the acquisition by an investor group led by Ford of a combination of approximately $80 million in exchangeable non-cumulative preferred stock of FIL and warrants to acquire additional common stock of Fremont.  Fremont stated that the reason for Mr. Ford's new-found hesitance was "in light of certain developments pertaining to the Company and FIL."  Well, that is helpful disclosure.  But, I surmise that this could be another material adverse change case, and that is how it is being spun in the press

Our starting point on these things, as always, is the MAC clause itself which is defined in the Investment Agreement as follows:

“Material Adverse Effect” means any material adverse effect on the retail deposit business or financial condition of the Company and its Subsidiaries taken as a whole; provided, however, that none of the following shall be deemed to constitute or shall be taken into account in determining whether there has been a “Material Adverse Effect”: any event, circumstance, change or effect arising out of or attributable to (a) any decrease in the market price of the Common Stock (excluding any event, circumstance, change or effect that is the basis for such decrease), (b) any changes in the United States or global economy or capital, financial or securities markets generally, including changes in interest or exchange rates, (c) any changes in general economic, legal, regulatory or political conditions in the geographic regions in which the Company and its Subsidiaries operate, (d) any events, circumstances, changes or effects arising from the consummation or anticipation of the transactions contemplated by this Agreement or the Sale Transactions or the announcement of the execution of this Agreement or the announcement of the Sale Transactions, (e) any events, circumstances, changes or effects arising from the compliance with the terms of, or the taking of any action required by, this Agreement, (f) any action taken by the Company or any of its Subsidiaries at the request or with the consent of the Investor, (g) any litigation brought or threatened by the stockholders of the Company arising out of or in connection with the existence, announcement or performance of this Agreement or the transactions contemplated hereby or the Sale Transactions, (h) changes in law, GAAP or applicable regulatory accounting requirements, or changes in interpretations thereof by any Governmental Entity, (i) any outbreak of major hostilities in which the United States is involved or any act of terrorism within the United States or directed against its facilities or citizens, wherever located, (j) earthquakes, hurricanes, floods or other natural disasters, (k) a failure by the Company to report earnings or revenue results in any quarter ending on or after the date hereof consistent with the Company’s historic earnings or revenue results in any previous fiscal quarter, including any failure to file with the Commission audited or unaudited financial statements for the year ended December 31, 2006 or any subsequent period, (l) any loss, liability or expense arising out of or relating to the contractual rights of third parties relating to the sale of residential mortgage loans prior to the date of this Agreement, or (m) any matter set forth in Section 1.1(a) of the Company Disclosure Schedule, except in the case of the foregoing clauses (i) and (j), to the extent such changes or developments referred to therein would reasonably be expected to have a materially disproportionate impact on the retail deposit business or financial condition of the Company and its Subsidiaries, taken as a whole, relative to other industry participants or enterprises (solely with respect to clause (i), located in the same geographic region as the Company and its Subsidiaries).

First off, read exclusion clause (m).  As an initial matter, placing exclusions in the Disclosure Schedule from the MAC clause is a pet peeve of mine.  Since disclosure schedules are not publicly disclosed this allows the parties to maintain these items as confidential.  But the practice may in some cases violate the federal securities anti-fraud rules.  This is because the merger agreement is considered by the SEC to be public disclosure; Fremont is therefore liable for material omissions -- and these non-disclosed items on the disclosure schedule may arise to that.  Whether they do or not we don't know since we can't see them, but the fact that Fremont didn't want them disclosed is telling.  Fremont's lawyers would do well to read this article which describes the SEC enforcement case against Titan Corp. on grounds of non-disclosure of items in the disclosure schedule.

More importantly, after exclusion (m) there is a qualifier for clauses (i) and (j).  This qualifier states that these exclusions do not count:  "except in the case of the foregoing clauses (i) and (j), to the extent such changes or developments referred to therein would reasonably be expected to have a materially disproportionate impact on the retail deposit business or financial condition of the Company and its Subsidiaries, taken as a whole, relative to other industry participants or enterprises (solely with respect to clause (i), located in the same geographic region as the Company and its Subsidiaries)."  First, note that unlike SLM, here the lawyers negotiated a materiality qualifier to the requirement of disproportionality.  Gold star for that one.  But, now read clauses (i) and (j).  These clauses deal with an outbreak of hostilities or natural disasters.  It is hard to believe that the parties wanted these exclusions to be qualified by disproportionality.  For example, under the clause as drafted, any earthquake that effected Fremont materially and disproportionally is still a MAC?  It can't be. 

This appears to be a mistake by the lawyers on the deal -- Skadden and Gibson, Dunn.  Instead, the qualifier was likely meant to qualify clauses (c) and (d) which address industry events.  This would be the standard qualifier to these exclusions; the ones where a disproportionality standard is typically applied.  I didn't see any amendment correcting this "mistake".  The result is to make the MAC much tighter than desired by Ford.  Be careful out there folks -- these mistakes do matter, significantly. 

Addendum:  I haven't looked more particularly at the facts of the Frontier case, but note that this is a very tight MAC without a forward looking element and with wide exclusions, including an exemption from the MAC clause for a failure to meet projections and for a failure to file audited and unaudited financial reports.  If Ford is indeed proclaiming a MAC, it will have to be an event which has already occurred and is particularly adverse and unique to Frontier to be sustained.  Nonetheless, in its press release Frontier may be admitting that such an event has indeed occurred by its willingness to negotiate with Ford for new terms. 

Of course, this all assumes that it is indeed the MAC clause upon which Ford is basing his claims that he is not required to close the transaction.  Stay tuned.

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