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Thursday, September 27, 2007

SLM: The Legal Case (Redux)

The dispute between SLM Corp. and its potential acquirers, J.C. Flowers & Co., Bank of America and JPMorgan Chase, went very live yesterday when SLM issued a press release stating:

SLM Corporation, commonly known as Sallie Mae, announced today that it has been informed by a representative of the buyer group led by J. C. Flowers, Bank of America and JPMorgan Chase that the buyer group does not expect to consummate the acquisition of Sallie Mae under the terms of the merger agreement. Sallie Mae firmly believes that the buyer group has no contractual basis to repudiate its obligations under the merger agreement and intends to pursue all remedies available to it to the fullest extent permitted by law.

Additionally, Sallie Mae noted the following: In response to Congress’ passage of the College Cost Reduction and Access Act of 2007 (the “Act”) and President Bush’s expected signing of the Act tomorrow, Sallie Mae has measured the Act’s adverse changes versus the impact of similar legislation described in the company’s SEC Form 10-K and concluded such changes would reduce “core earnings” net income, between 1.8 percent and 2.1 percent annually over the next 5 years, using business assumptions it has shared with the buyer group.

Translating this press release, the Flowers consortium is likely claiming that the new legislation constitutes a material adverse change to SLM and that consequently it is no longer required to complete the acquisition.  Clearly, the Flowers consortium is, at a minimum, posturing for a price renegotiation.  As such, SLM's statement is similar posturing to push through the deal. 

To determine if either argument is valid, the starting starting point is the merger agreement and its definition of MAE:

"Material Adverse Effect” means a material adverse effect on the financial condition, business, or results of operations of the Company and its Subsidiaries, taken as a whole, except to the extent any such effect results from: (a) changes in GAAP or changes in regulatory accounting requirements applicable to any industry in which the Company or any of its Subsidiaries operate; (b) changes in Applicable Law provided that, for purposes of this definition, “changes in Applicable Law” shall not include any changes in Applicable Law relating specifically to the education finance industry that are in the aggregate more adverse to the Company and its Subsidiaries, taken as a whole, than the legislative and budget proposals described under the heading “Recent Developments” in the Company 10-K, in each case in the form proposed publicly as of the date of the Company 10-K) or interpretations thereof by any Governmental Authority; (c) changes in global, national or regional political conditions (including the outbreak of war or acts of terrorism) or in general economic, business, regulatory, political or market conditions or in national or global financial markets; that such changes do not disproportionately affect the Company relative to similarly sized financial services companies and that this exception shall not include changes excluded from clause (b) of this definition pursuant to the proviso contained therein; (d) any proposed law, rule or regulation, or any proposed amendment to any existing law, rule or regulation, in each case affecting the Company or any of its Subsidiaries and not enacted into law prior to the Closing Date; (e) changes affecting the financial services industry generally; that such changes do not disproportionately affect the Company relative to similarly sized financial services companies and that this exception shall not include changes excluded from clause (b) of this definition pursuant to the proviso contained therein; (f) public disclosure of this Agreement or the transactions contemplated hereby, including the initiation of litigation by any Person with respect to this Agreement; (g) any change in the debt ratings of the Company or any debt securities of the Company or any of its Subsidiaries in and of itself (it being agreed that this exception does not cover the underlying reason for such change, except to the extent such reason is within the scope of any other exception within this definition); (h) any actions taken (or omitted to be taken) at the written request of Parent; or (i) any action taken by the Company, or which the Company causes to be taken by any of its Subsidiaries, in each case which is required pursuant to this Agreement.

The first issue is the most important -- whether SLM has even experienced a MAC.  Here, the agreement is governed by Delaware law.  In In re IBP, Inc. Shareholders Litigation (“IBP”), 789 A.2d 14 (Del. Ch. 2001) and Frontier Oil Corp. v. Holly, the Delaware courts set a high bar for proving a MAC.  Under these cases the party asserting a MAC has the burden of proving that the adverse change will have long-term effects and must be materially significant.  SLM stated yesterday that the new legislation will reduce "'core earnings' net income, between 1.8 percent and 2.1 percent annually over the next 5 years."  The press release is too tightly, and maybe cleverly, drafted for me.  After reading it three times, I'm still not sure what "core earnings" net income is nor am I sure whether SLM is stating that this is the total decline or only the decline compared to the Act’s adverse changes versus the impact of similar legislation described in the company’s SEC Form 10-K. But perhaps, I am missing something. 

In any event, the test of a MAC is quite fact dependent and looks at the effect on the entire company, and so a significantly adverse decline in revenue or earnings as a whole should theoretically suffice.  So, there may be more here that SLM is not currently disclosing which may substantiate a MAC claim.  By the way, for those wondering how bad it has to be to be "materially significant", I wish I could give you a definitive answer -- there is little case-law on this, but the practitioner rule of thumb is generally a 10% decline in income would be a MAC.  Though some will tell you that the GAAP measurement of 5% is good enough -- there is just not enough case-law on this and it is sometimes conflicting.  Compare Pan Am Corp. v. Delta Airlines, Inc., 175 B.R. 438, 493 (S.D.N.Y. 1994) (holding that significant deteriorations of business performance and business prospects – declines of 20% to 40% in advance bookings – constituted a MAC) with Polycast Technology Corp. v. Uniroyal, Inc., 792 F. Supp. 244, 253, 274 (S.D.N.Y. 1992) (deciding that the cancellation of a major profitable customer contract is arguably a MAC).  It is clear, though, that IBP and Frontier have set a high bar for proving a MAC.  This may be the case here with SLM -- though they have yet to release what the total impact of this new legislation is on them -- a telling non-disclosure. 

However, if the Flowers consortium can prove a MAC there is still the matter of the highlighted carve-outs above.  On these, expect SLM to argue the following:

  1. The new legislation is not, on the whole, more adverse than described in its 10-K (exclusion (b)); and
  2. The change is to the financial services industry generally and is not disproportionate to SLM (exclusion (e)).

In these two carve-outs the parties agree that these events do not constitute a MAC even if they are a materially adverse change.  The interesting thing here is that these are not qualified by "materiality".  So, the Flowers consortium will likely argue that it need only prove that the change is materially adverse to the company and is either adverse (in the case of 1) or disproportionate (in the case of 2) in any amount to SLM.  A cent of adverseness or disproportionality would arguably work here, and SLM has previously admitted there is an adverse impact over and above the matters disclosed in (b) and appears to be doing so in yesterday's press release as well. [Also, note the exclusion in (e) -- it specifically excludes changes excluded from clause (b) under the proviso].  Ultimately, this is again a fact-based determination, but it appears that Flowers has a bit of a way to go here to prove a MAC though it is very much helped by the lack of materiality qualifiers in the carve-outs, and SLM's admissions with respect thereto.  And, Flowers has the virtue of being able to highlight the highly negotiated MAC on this point which clearly contemplated this event -- since here it appears that the legislation is worse than expected, Flowers will argue this is exactly what they negotiated for. 

And as I stated two weeks ago:

All of this may not matter much as the Flowers consortium also has a walk-away right under the agreement if it pays a reverse termination fee of $900 million dollars.  This changes the negotiating position of the Flowers group substantially.  Expect them to attempt to preserve their reputation for not walking from deals by publicly proclaim a MAC has occurred, but privately claim that the deal calculus now makes it more economical to walk.  The consortium will find encouragement from their bankers who may also now find it more economical to simply pay or share the reverse termination fee with the buyers.  This would be a similar renegotiation that occurred in Home Depot's sale of its supply business which ended with a cut of eighteen percent in the deal price. 

Reading tea-leaves, I would expect Flowers to use the reverse termination fee and colorable MAC claims to negotiate some form of price cut.  But, as with most MAC renegotiations, expect it to happen behind closed doors.  Any renegotiation will require a new shareholder vote, so even if there is a renegotiation there will not be a closing in the immediate future. 

My prediction still stands, and appears to be coming to pass.  However, I would say that litigation over this deal is now more likely than a price renegotiation given the passage of time and continuing failure of the parties to reach an agreement.  Remember, if there is any litigation it will not be over whether the deal should be completed but whether a MAC does or does not exist.  If it does, the Flowers consortium is not required to complete the deal.  If it does not, Flowers is still not required to complete the deal.  Rather, the only recourse of SLM is to collect the $900 million dollars and the parties to go their own way or agree to a renegotiated deal, if the Flowers consortium is willing. 

As a law professor, I'm rooting for such litigation as the additional case-law will give more definition under Delaware law to what does constitute a MAC and may resolve issues concerning how "disproportional" the MAC change must be under the fairly standard industry exclusions above -- a question which was also at issue in Lone Star/Accredited Home Lenders. 

Addendum:  One further point -- SLM will also argue that Flowers already knew of the possibility of this legislation at the time of the agreement and accepted that risk.  Here they will be relying on the disclosure in the merger agreement and disclosure schedules as well as its public filings but also invoking the spirit of Bear Stearns Co. v. Jardine Strategic Holdings, No. 31371187, slip. op. (N.Y. Sup. Ct. June 17, 1988), aff’d mem., 533 N.Y.S. 2d 167 (App. Div. 1988)  which held that a bidder for 20% of Bear Stearns could not rely on MAC to avoid contract despite $100 million loss by Bear Stearns on Black Monday, October 19, 1987 and the first quarterly loss in Bear Stearn’s history. The buyer knew that Bear Stearns was in a volatile cyclical business.  In short, the Flowers consortium knew what it was getting into here.  But then again clause (b) was clearly meant to address this issue. 

Final Conclusion:  A number of people emailed me today to ask what my ultimate conclusion was.  Well, this is a very fact-dependent analysis and we do not have all the facts, but, I think Flowers has a good case here that a MAC occurred particularly since this issue was so highly negotiated and accounted for in the MAC and what is happening now appears to be worse.  Certianly, their case is no slam dunk, but I believe they have enough of a claim to push through a renegotiation of the price if they want.  This is a risk which Flowers et al. can more easily take given that their liability is limited to $900 million if they are wrong.  So, I once again predict a renegotiated, lower price. 

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