September 19, 2007
PHH Corp's Vague Condition
The Wall Street Journal yesterday ran an article on PHH Corp. which has an agreement to be acquired by General Electric Capital Co. and Blackstone Group LP for $1.7 billion. GE is buying the entire business and on-selling PHH's mortgage lending business to Blackstone. On Monday, PHH Corp. announced that J.P. Morgan Chase & Co. and Lehman Brothers Holdings Inc., the banks who had committed to finance Blackstone's purchase, had "revised [their] interpretations as to the availability of debt financing". This revision could result in a shortfall of up to $750 million in available debt financing for Blackstone's purchase. According to PHH, the GE acquisition vehicle Pearl Acquisition had:
stated in the letter that it believes that the revised interpretations were inconsistent with the terms of the debt commitment letter and intends to continue its efforts to obtain the debt financing contemplated by the debt commitment letter as well as to explore the availability of alternative debt financing. Pearl Acquisition further stated in the letter that it is not optimistic at this time that its efforts will be successful and there can be no assurances that these efforts will be successful or that all of the conditions to closing the merger will be satisfied.
In their article, The Wall Street Journal spun the story as illustrating the increasing willingness of investment banks to assertively rely on contractual terms to back away from financing commitments to private equity groups, clients which have been some of the bank's best customers in recent years. This may clearly be the case here, and if so, this highlights the lingering problems in the credit and deal markets (at least pre-Fed cut -- moral hazard, folks), and the bad financial position of the banks on these loans which makes them willing to challenge their best customers. But there is perhaps an alternative explanation -- the banks as well as Blackstone no longer like this deal and are now both incentivized to back away from it. However, for public relations purposes Blackstone is trying to play the good guy.
This explanation -- the purchasers and banks are all working together to stem losses from a bad deal -- finds support in the agreements PHH struck to be acquired. In the merger agreement, PHH agreed to condition the obligations of GE on:
All of the conditions to the obligations of the purchaser under the Mortgage Business Sale Agreement to consummate the Mortgage Business Sale (other than the condition that the Merger shall have been consummated) shall have been satisfied or waived in accordance with the terms thereof, and such purchaser shall otherwise be ready, willing and able (including with respect to access to financing) to consummate the transactions contemplated thereby . . . .
Does everyone see the problem with this language? I usually hesitate to criticize drafting absent knowing the full negotiated circumstances and without having context of all the negotiations, but this is poor drafting under any scenario. "ready, willing and able"? I have no idea what the parties and DLA Piper, counsel for PHH intended this to mean, but arguably Blackstone -- the mortgage business purchaser here -- can simply say that is not a willing buyer for any reason and GE can then assert the condition to walk away from the transaction. You can read "ready" and "able" in similarly broad fashion. This is about as broad a walk-away right as I have ever seen -- I truly hope that PHH realized this, or were advised to this, when they agreed to it.
Here, note that the walk-away right is GE's. GE can either waive or assert the condition if Blackstone is not "ready, willing or able". It does not appear that PHH has disclosed the agreement between GE and Blackstone with respect to the Mortgage Business Sale. But, in PHH's proxy, PHH states that the mortgage business sale is conditioned upon the satisfaction or waiver of the closing conditions pertaining to GE in the merger agreement. In addition PHH stated that:
In connection with the merger agreement, we entered into a limited guarantee, pursuant to which Blackstone has agreed to guarantee the obligations of the Mortgage Business Purchaser up to a maximum of $50 million, which equals the reverse termination fee payable to us under certain circumstances by the Mortgage Business Purchaser in the event that the Mortgage Business Purchaser is unable to secure the financing or otherwise is not ready, willing and able to consummate the transactions contemplated by the mortgage business sale agreement.
I can't read the actual terms because the agreement is unavailable, but this may ameliorate a bit the bad drafting. PHH has essentially granted a pure option to Blackstone to walk for $50 million. The interesting thing here is how all of this works with GE in the middle. We can't see the termination provisions of the mortgage business sale agreement between GE and Blackstone but presumably Blackstone can walk from that agreement by paying the $50 million to PHH -- what its obligations to GE in such a case are we don't know.
Ultimately, though, the problem is that these provisions provide too much room for all three of GE, Blackstone and the Banks to maneuver to escape this transaction. GE can simply work with Blackstone to have it assert that it is unwilling to complete the transaction for any plausible reason; Blackstone can similarly rely upon the Banks actions and what is likely a loosely drafted commitment letter to make such a statement or come up with another one. The end-result is to place very loose reputational restraints on the purchasers' ability to walk from the transaction. Compare this with other private equity deals with similar option-type termination fees. There, the private equity firms have to actually breach the merger agreement and their commitments to walk. This is a powerful constraint as the private equity firms do not want to squander their reputational capital by appearing to be unreliable on their deal commitments. Here, the problem is that the drafting of the merger agreement condition allows Blackstone to walk for any reason and GE to rely on that to terminate its own obligations. This is a much lighter reputational constraint -- they do not need to breach the agreement and their commitments to terminate the deal. The result is exactly what is happening here. If the deal goes bad the purchasers have little incentive to keep from cutting their losses and walking, and wide latitude to appear to be doing so for the right reasons and in accordance with their commitments. And this is why this is not only poor drafting, but a poor agreement for PHH to have made.
Addendum: As a comment notes there are also disclosure issues here. Although Form 8-K and Form 14A (for proxy statements) arguably don't require PHH to disclose the on-sale agreement since PHH is only a third party beneficiary and not a party to this agreement, they likely should have disclosed the agreement on general materiality grounds.
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Your comments above also highlight the disclosure issue. Key agreements that effect the probability of closing were never disclosed which would seem to be a fairly obvious violation of the securities laws.
Posted by: Richard Bliss, CFA | Sep 19, 2007 5:32:59 AM