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Boston College Law School

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Sunday, September 23, 2007

The Mystery of Harman

The Harman deal collapsed spectacularly on Friday.  It began with a morning Wall Street Journal story reporting that KKR and Goldman Sachs Capital Partners had soured on their $8 billion purchase of the audio equipment maker.  The story reported that KKR & GSCP were trying to claim a material adverse change and otherwise were going to walk from the deal.  The Journal correctly noted that KKR and GSCP could simply break their commitments to acquire Harman by paying a reverse termination fee of $225 million.  Perhaps most interestingly, the WSJ also reported that "KKR has solicited some of the lending banks to help pay part of that fee, said one person familiar with the matter, but the banks have resisted the effort." 

Later in the day just before market close, Harman issued a press release stating:

Harman International Industries, Incorporated (NYSE:HAR - News) announced that it was informed this afternoon that Kohlberg Kravis Roberts & Co. L.P. (KKR) and GS Capital Partners VI Fund, L.P. (GSCP) no longer intend to complete the previously announced acquisition of Harman by a company formed by investment funds affiliated with or sponsored by KKR and GSCP. KKR and GSCP have informed Harman that they believe that a material adverse change in Harman's business has occurred, that Harman has breached the merger agreement and that they are not obligated to complete the merger. Harman disagrees that a material adverse change has occurred or that it has breached the merger agreement.

KKR's and GSCP's MAC claim came as a complete surprise to the market.  Harman had filed their annual report on Form 10-K on Aug 29.  At the time, it did not appear to have disclosed any materially adverse change with respect to Harman.  Moreover, although Harman's second quarter results declined and were below expectations, if there was a further marked deterioration thereafter in July or August Harman was required to disclose it in their Form 10K.  But they didn't -- I am therefore unable to see any information in the public domain which substantiates a MAC (please correct me if my conclusion is wrong).  I surmise from this that the KKR consortium has soured on this deal for other than financial reasons, perhaps strategic or management related.  This conclusion is buttressed by the WSJ news report that the bank didn't want to participate in funding the reverse termination fee.  If there were financial problems, you would think the banks would have lunged head first to get out of this deal as with Home Depot, Genesco, PHH, etc.  Of course, the information in the Journal could have been planted by the banks -- who knows?  In short, the whole thing is a mystery right now -- we need more information. 

More importantly, it is not even worth much to go into whether KKR's claim is true (although for those interested I have an analysis at the end here).  This is because the Harman/KKR merger agreement has a reverse termination fee and the contract specifically excludes specific performance.  This limits KKR's and GS's damages in case of any breach of the agreement to $225 million or 2.7% of the transaction value.  Can everyone see why this is different than Accredited Home Lenders/Lone Star and Genesco/Finish Line?  There, there was/is no reverse termination fee.  So, AHL and Genesco can sue for specific performance and completion of the deal.  If Finish Line loses (or Lone Star had lost) they would have been required to complete the deal.  Here in Harman, the only issue is over the measly $225 million.  If KKR and GS prove a MAC occurred then they do not have to pay it and can walks; if they can prove it then they pay nothing  and can walk(except the substantial commitment fees in their financing letters).  This deal is dead -- there is no chance of salvaging it -- the only issue is if Harman gets $225 million.  And that is one of the reasons why Harman's stock cratered on the news on Friday.  It is also why these reverse termination fees are so pernicious in their effects. 

So, ultimately, given the lack of information substantiating a MAC, KKR and GSCP may be claiming a MAC almost solely to protect their reputational capital.  They do not want to appear to be walking on the deal so are asserting an ostensible claim of a MAC.  This provides cover for them so that they do not appear to be the type of buyers who break deals; in short they remain the good guys.  But still, there must be something wrong in this deal, given that KKR and GSCP would be willing to walk here, possibly lose reputational capital (for those who see through their MAC claims if indeed they are unsubstantiated) and risk paying the $225 million and losing their commitment fees.  Again, what is wrong is a mystery, and yet another reason why Harman's stock price fell so far on Friday -- the market hates uncertainty. 

NB.  One of the interesting things about this deal was the equity participation right that shareholders had to retain an interest in Harman once it was acquired by KKR & GSCP.  At the time, I hailed this structure, stating:

I've blogged before about the perils of management participation in private equity buy-outs.  Their participation is likely to give an undue and trumping head start to their chosen private equity firm(s) due to management's head-start, superior information and ability to (unduly) influence the acquisition process even when a special committee is present.  To ameliorate this problem, special committees have been negotiating "go-shops" like the one here [in Harman]. . . . But investors have increasingly come to see "go-shop" provisions as cover for unduly large break-up fees and the significant advantage and head-start provided by management participation. . . . . the shareholder participation feature [in Harman is therefore] encouraging.  It gives shareholders a real option to participate in what may be seen as a management cash-out.  It may be a good solution to some of the problems with management/private equity partnered buy-outs. . . .

Unfortunately, the problem of unintended effects arose here.  The registration statement for the stub equity is a document which must be prepared by KKR and GSCP.  Thus, the inclusion of this stub equity provided KKR and GSCP the ability to control the timing of the transaction to a greater extent than usual and pushed out the timeline no matter what in order to permit time to prepare this registration statement.  This ultimately worked against Harman and its shareholders.

Addendum:  MAC analysis

Material adverse change in Section 3.01 of the Harman merger agreement is defined as:

“Company Material Adverse Effect” means any fact, circumstance, event, change, effect or occurrence that, individually or in the aggregate with all other facts, circumstances, events, changes, effects, or occurrences, (1) has or would be reasonably expected to have a material adverse effect on or with respect to the business, results of operation or financial condition of the Company and its Subsidiaries taken as a whole, or (2) that prevents or materially delays or materially impairs the ability of the Company to consummate the Merger, provided, however, that a Company Material Adverse Effect shall not include facts, circumstances, events, changes, effects or occurrences (i) generally affecting the consumer or professional audio, automotive audio, information, entertainment or infotainment industries, or the economy or the financial, credit or securities markets, in the United States or other countries in which the Company or its Subsidiaries operate, including effects on such industries, economy or markets resulting from any regulatory and political conditions or developments in general, or any outbreak or escalation of hostilities, declared or undeclared acts of war or terrorism (other than any of the foregoing that causes any damage or destruction to or renders physically unusable or inaccessible any facility or property of the Company or any of its Subsidiaries); (ii) reflecting or resulting from changes in Law or GAAP (or authoritative interpretations thereof); (iii) resulting from actions of the Company or any of its Subsidiaries -which Parent has expressly requested or to which Parent has expressly consented; (iv) to the extent resulting from the announcement of the Merger or the proposal thereof or this Agreement and the transactions contemplated hereby, including any lawsuit related thereto or any loss or threatened loss of or adverse change or threatened adverse change, in each case resulting therefrom, in the relationship of the Company or its Subsidiaries with its customers, suppliers, employees or others; (v) resulting from changes in the market price or trading volume of the Company’s securities or from the failure of the Company to meet internal or public projections, forecasts or estimates provided that the exceptions in this clause (v) are strictly limited to any such change or failure in and of itself and shall not prevent or otherwise affect a determination that any fact, circumstance, event, change, effect or occurrence underlying such change or such failure has resulted in, or contributed to, a Company Material Adverse Effect; or (vi) resulting from the suspension of trading in securities generally on the NYSE; except to the extent that, with respect to clauses (i) and (ii), the impact of such fact, circumstance, event, change, effect or occurrence is disproportionately adverse to the Company and its Subsidiaries, taken as a whole.

The MAC here is fairly standard except that it does not include an exception for failure to meet financial projections -- this makes it tighter than usual.   It also defines a MAC to include any event "that prevents or materially delays or materially impairs the ability of the Company to consummate the Merger".  You see this sometimes, but its inclusion is problematical because it broadens what can be defined as a MAC, and, given the vagueness, obviously provides more grounds for a buyer to claim a MAC has occurred.  Ultimately, I am not sure what events the parties meant to cover here but they arguably picked up any problems which delay the financing.  Moreover, the drop-dead date is meant to deal with delays.  By including material delay here they have to mean something short of postponing a deal past the drop dead date.  But I can't believe that was intended.  M&A lawyers would do well to avoid including this clause because of these problems.  In any event, if KKR & GSCP are indeed claiming a MAC, I would expect them to rely on this clause because of its vagueness and broad scope. 

Otherwise, the agreement is governed by Delaware law.  Harman's public disclosure thus far does not appear to establish a MAC under the first clause of the definition under Delaware case law, but again perhaps I am missing something or it relates to something not disclosed. 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.  Moreover, KKR & GSCP would also need to prove in this case and under clause (2) of the MAC definition that the change was not disproportional to those "generally affecting the consumer or professional audio, automotive audio, information, entertainment or infotainment industries, or the economy or the financial, credit or securities markets, in the United States or other countries in which the Company or its Subsidiaries operate".  Unfortunately, what constitutes a disproportional changes was an issue that could have been resolved in the Delaware courts by the AHL/Lone Star case before it settled.  Again, we would need more information about the MAC claim here to know if it came under the exception.  More mystery. 

Final, Final Note:  also, as with the SLM MAC clause, note that the need for disproportionality here is not material.  So, $1 of disproprotionality will do.  Again, M&A lawyers would do well to modify this clause in their own agreements if they do not intend for this. 

Update:  Harman this morning released financial guidance to the market.  Harman stated:

The Company expects fiscal 2008 performance to be impacted by a number of factors including increased R&D to support the development of several new infotainment platforms and associated launch costs. We now expect fiscal 2008 sales to reach $4.1 billion ($3.55 billion in 2007). The Company expects operating income and diluted EPS before merger related costs to equal or exceed last years record performance. In 2007, operating income was $397 million and diluted EPS were $4.14 adjusted for non-recurring restructuring charges, merger costs and tax items. . . . .

We expect substantial margin improvements over the course of fiscal 2008 as we work through these costs and begin the launching of new infotainment platforms.

In light of increases in material costs and faster ramp-up of R&D resources to work on new business awards, equaling the record operating performance of fiscal 2007 is an achievement. The benefits of common platform synergy and scalability will be realized in fiscal 2009 and beyond. Those benefits will strengthen our operating profits. . . . .

To the extent that Harman is legal posturing they are asserting that any decline in earnings or revenue is not long term and merely a short term failure.  The Delaware courts in IBP/Tyson found such a short-term event not to constitute a MAC.  Although, we are only getting Harman's side of the story.  And, for purposes of the merger, it doesn't really matter as the $225 million is the only thing at stake.  For those who want more, the company is going to have a conference call at 4:30 p.m. EDT on September 27, 2007, to discuss its current expectations for fiscal 2008.  However, Harman helpfully stated in its press release that it will not "accept questions about the proposed merger with affiliates of Kohlberg Kravis Roberts & Co. L.P. and GS Capital Partners VI Fund, L.P." 

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Comments

I appreciate how well-written your blog is. Very intelligent. I came out to the same conclusions as you did except that I have not completely ruled out specific performance.

With regards to HAR deal, what do you think about HAR seeking specific performance? I understand the contract differences between Accredited and Genesco, and I understand the probability is not high, but I'm trying to figure out if there is any chance of specific performance. Your analysis seems to imply no chance so let me play Devil's Advocate.

- First, courts routinely over-ride the remedy agreed to in contracts.

- Second, the Tyson/IBP opinion did not reference the Agreement language in determining specific performance was the proper remedy.

- Third, the Tyson/IBP Agreement did not mention specific performance.

- Fourth, the logic of the Termination section does not preclude specific performance until the final catch-all sentence. Until then, the logic seems to offer the $225mm Termination Feee as an option to the aggrieved party.

- Fifth, the $225mm Termination Fee seems inadequate for an $8bn merger.

- Sixth, the Delaware courts clearly want to send the public policy message that Buyers do not get free options (or cheap options) when purchasing public companies.

Thoughts on whether the specific performance argument has a snowball's chance in hell of prevailing?

Posted by: Adam | Sep 24, 2007 6:17:07 AM

Very well written analysis indeed (as always). I have found your previous blogs very fascinating as well. However, I have one thing to point out and one question to ask:

First, you stated that there was no reversed termination fee for the Accredited / Lone Star deal, but I believe there is a "Parent Termination Fee" of USD 12m in the original Tender Offer (http://www.sec.gov/Archives/edgar/data/1174735/000119312507138436/dex99a1a.htm) (just do search for termination and you will see it toward the bottom) and later there was a supplement to the offer that decreased the amount of "Parent Termination Fee" to USD 6m (http://www.sec.gov/Archives/edgar/data/1174735/000119312507205510/dex99a1h.htm).

Second, it would seem that you were implying that if there is a reversed termination fee in placed (as seen in Accredited / Lone Star) then the buyer can definitely walk away and just pay the fee. This was not the case with Accredited as we all saw what happened, or perhaps it had to do with it being a Tender Offer instead of a Merger Agreement? In any case, I read through the termination conditions of Harman's deal, it would seem that the reversed termination is conditional, and that's why the buyers are pulling the MAC move (and perhaps for the image reason also) on Harman. Will you please point out the exact sentence(s) or paragraph(s) in which would give the buyers the right to walk away from the deal at any time they so desire? Just being a Devil's Advocate here, but you did mention that "the deal is dead."

- An extremely curious reader/fan

Posted by: Kay | Sep 26, 2007 9:02:09 AM

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