October 2, 2007
3Com -- Surprise. Surprise.
Yesterday, 3Com filed its merger agreement. As I read it, I felt like one of those cult members who predicts the end of the Earth on a date certain and wakes the day after to find everything still there. Do they repent? No, they fit the new facts into their situation and keep their belief.
Well, 3Com did not go the Avaya route as I predicted. Instead, they kept to the old private equity structure and included a highly negotiated reverse termination fee structure. Essentially, 3Com and their lawyers (Wilson Sonsini) agreed that the buyers (Bain and Huawei) have a pure walk right if they pay a termination fee of $110,000,000 (Section 8(j) of the merger agreement). This is about 5% of the transaction value of $2.2 billion. And in certain situations, such as if the debt financing falls through, the buyers would only be liable for $66,000,000 if they breach the merger agreement and walk (I spell out these situations at the end of this post).
So, how do we explain this? Well, one of the other interesting things about the 3Com merger agreement is that it is not conditioned upon financing; a fact 3Com did not even publicize in its press release or make an explicit condition in the merger agreement. So, I think the conversation went something like this: 3Com -- we can't agree to this reverse termination fee as it will give you too much optionality. Bain -- OK, well we can't expose our investors to liability for the full purchase price; if you won't agree to this then we need a financing condition. Plus, we are really nice people and would never do that to you. Banks piling on -- we won't finance this deal if there is specific performance on our commitment letters. 3Com -- OK -- no financing condition -- but we want a high termination fee of 5% to compensate us if you do indeed walk without a reason. So, like the cult survivor this is my best explanation in order to keep my belief in rational negotiating, although there is a lower termination fee if the financing falls through, so I am still struggling to see the logic of the terms here. In their conference call on Friday, 3Com was particularly unhelpful in talking about the terms of the agreement -- refusing to answer questions on the amount of the Huawei investment and instead stating "you’re going to have to wait a couple days or a little while before you can get specific answers to those questions." They were also a bit defensive about the fact that one analyst suggested that if you exclude 3Com's ownership of H3C it values the remainder of 3Com at "$0.75, $0.80" a share. Ouch.
I'm also a bit troubled by some of the other terms which 3Com and its lawyers negotiated. First, there is no go-shop in the transaction. Even though these provisions have their problems (see my post on this here), it does provide some opportunity for other bidders to emerge and shields the seller from claims of favoritism, so I am a bit surprised 3Com did not include it. In addition, if 3Com shareholders vote down the transaction, 3Com agreed in clause 8.3(b)(v) to reimburse the buyers for their fees and expenses up to $20 million. This is unusual and an excessive amount of money for 3Com to pay merely because its shareholders exercised their statutory voting rights to reject the deal. The termination fee in case of a competing bid is a market standard of $66 million (3% of the deal value) and does not require that the company pay the fees and expenses of the buyers.
I think the most annoying part of the agreement from my perspective was this clause 7.1(b) which conditioned the merger occurring on:
(b) Requisite Regulatory Approvals. (i) Any waiting period (and extensions thereof) applicable to the transactions contemplated by this Agreement under the HSR Act shall have expired or been terminated, (ii) any waiting periods (and extensions thereof) applicable to the transactions contemplated by this Agreement under the Antitrust Laws set forth in Schedule 7.1(b) shall have expired or been terminated, and (iii) the clearances, consents, approvals, orders and authorizations of Governmental Authorities set forth in Schedule 7.1(b) shall have been obtained.
Read the highlighted condition. Of course, 3Com did not disclose Schedule 7.1(b) and refused to answer questions on the agreement on their conference call yesterday. So, investors at this point still don't know all of the conditions to the deal. I can't see how this is not a material omission in violation of the federal securities laws (read my post on the SEC action against Titan). I really wish the SEC would crack down on this practice since a shareholder action on this claim is a loser because of the holding in Dura Pharmaceuticals (see my post on this here). It is particularly important here because the inclusion of a Chinese buyer might lead to an Exon-Florio filing for this deal. And the condition that we can't see might be exactly that -- a condition that Exon-Florio clearance is required to complete the deal. Given that this is a Chinese buyer it is bound to attract CFIUS scrutiny whether justified or not. In this case, it may be justified -- apparently sharing 3Com's networking technology with the Chinese does raise national security concerns. (By the way, for an explanation of the Exon-Florio process and the term CFIUS see my first post today here). Shame on 3Com for not disclosing the condition immediately or even informing the public of the amount of the Chinese investment at this time. If 3Com is indeed going to clear Exon-Florio in this transaction they need to handle their public relations better.
Finally the MAC clause is in the definitions and states:
“Company Material Adverse Effect” shall mean any effect, circumstance, change, event or development (each an “Effect”, and collectively, “Effects”), individually or in the aggregate, and taken together with all other Effects, that is (or are) materially adverse to the business, operations, condition (financial or otherwise) or results of operations of the Company and its Subsidiaries, taken as a whole; provided, however, that no Effect (by itself or when aggregated or taken together with any and all other Effects) resulting from or arising out of any of the following shall be deemed to be or constitute a “Company Material Adverse Effect,” and no Effect (by itself or when aggregated or taken together with any and all other such Effects) resulting from or arising out of any of the following shall be taken into account when determining whether a “Company Material Adverse Effect” has occurred or may, would or could occur: (i) general economic conditions in the United States, China or any other country (or changes therein), general conditions in the financial markets in the United States, China or any other country (or changes therein) or general political conditions in the United States, China or any other country (or changes therein), in any such case to the extent that such changes, effects, events or circumstances do not affect the Company and its Subsidiaries in a disproportionate manner relative to other participants in the industries in which the Company and its Subsidiaries conduct business; (ii) general conditions in the industries in which the Company and its Subsidiaries conduct business (or changes therein) to the extent that such changes, effects, events or circumstances do not affect the Company and its Subsidiaries in a disproportionate manner relative to other participants in the industries in which the Company and its Subsidiaries conduct business; (iii) any conditions arising out of acts of terrorism, war or armed hostilities to the extent that such conditions do not affect the Company and its Subsidiaries in a disproportionate manner relative to other participants in the industries in which the Company and its Subsidiaries conduct business; (iv) the announcement of this Agreement or the pendency or consummation of the transactions contemplated hereby, including the impact thereof on relationships (contractual or otherwise) with suppliers, distributors, partners, customers or employees; (v) any action taken by the Company or its Subsidiaries that is required by this Agreement, or the failure by the Company or its Subsidiaries to take any action that is prohibited by this Agreement; (vi) any action that is taken, or any failure to take action, by the Company or its Subsidiaries in either case to which Newco has approved, consented to or requested in writing; (vii) any changes in Law or GAAP (or the interpretation thereof); (viii) changes in the Company’s stock price or change in the trading volume of the Company’s stock, in and of itself (it being understood that the underlying cause of, and the facts, circumstances or occurrences giving rise or contributing to such circumstance may be deemed to constitute a “Company Material Adverse Effect” (unless otherwise excluded) and shall not be excluded from and may be deemed to constitute or be taken into account in determining whether there has been, is, or would be a Company Material Adverse Effect; (ix) any failure by the Company to meet any internal or public projections, forecasts or estimates of revenues or earnings in and of itself (for the avoidance of doubt, the exception in this clause (ix) shall not prevent or otherwise affect a determination that the underlying cause of such failure is a Company Material Adverse Effect); or (x) any legal proceedings made or brought by any of the current or former stockholders of the Company (on their own behalf or on behalf of the Company) resulting from, relating to or arising out of this Agreement or any of the transactions contemplated hereby.
For those of you who have better things to do than slog through this definition, it is favorable to 3COM -- it contains no forward-looking element and specifically excludes failure to meet projections from the definition among other things.
Final Conclusion: 3Com is an unusual deal for a variety of reasons. In addition, the model in 3Com is one that Wilson Sonsini has negotiated in other deals (see, e.g., Acxiom). It may indeed signal that past practices here with respect to private equity deals and reverse termination fees will continue as the norm albeit with higher buyer reverse termination fees. But, like the cult survivor, for now I'm going to keep my belief and hope that its singularity will not effect future practice and that the Avaya model will become the standard. Or at least that firms other than Wilson Sonsini might learn quicker and go that route.
Addendum: Reverse Termination Fee.
The relevant termination clause here is clause 8.1(g) which permits termination:
(g) by the Company, in the event that (i) all of the conditions to the obligations of Newco and Merger Sub to consummate the Merger set forth in Section 7.1 and Section 7.2 have been satisfied or waived (to the extent permitted hereunder), (ii) the Debt Financing contemplated by the Debt Commitment Letters, Senior Secured Credit Agreement and/or Bridge Agreement (or any replacement, amended, modified or alternative Debt Commitment Letters, Senior Secured Credit Agreement and/or Bridge Agreement permitted by Section 6.4(b)) has funded or would be funded pursuant to the terms and conditions set forth in such Debt Commitment Letters, Senior Secured Credit Agreement and/or Bridge Agreement upon funding of the Equity Financing contemplated by the Equity Commitment Letters; (iii) Newco and Merger Sub shall have breached their obligation to cause the Merger to be consummated pursuant to Section 2.2 and (iv) a U.S. Federal regulatory agency (that is not an antitrust regulatory agency) has not informed Newco, Merger Sub or the Company that it is considering taking action to prevent the Merger unless the parties or any of their Affiliates agree to satisfy specified conditions (which may but need not include divestiture of a material portion of the Company’s business) other than as contemplated by Section 5.5 of the Company Disclosure Schedule, or such regulatory agency has informed the parties that it is no longer considering such action; or
If the agreement is terminated under this clause then the buyers are required to pay the Newco Default Fee ($110 million). The clause limiting the buyers to paying this amount is in 8.3(g) (Limitation of Remedies) and 9.7 (Specific Performance). Of particular importance, note that the debt financing must be funded for this termination provision to be triggered. If the debt financing or other conditions above are not met, the buyers are then liable for the lesser amount of $66 million for breaching the agreement (clause 8.3(c)(i)).
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I like your blog, but I wanted to point something out that I've noticed in a couple columns. You keep saying that these MAC's don't have a forward looking element, but you should look beyond the definition itself.
For example, in this deal, the closing condition is "No Effect shall have arisen or occurred following the execution and delivery of this Agreement that is continuing and that shall have had or be reasonably expected to have a Company Material Adverse Effect" -- they've put the forward looking element in the condition itself. Sometimes, when there is no explicit MAC condition, this "could reasonably be expected to" language is in the absence of changes rep itself (and remember there is always a condition that the reps are true at closing).
The reason people don't put it in the definition sometimes is that you get into situations where the "could/would reasonably be expected to" is doubled, meaning it's in the definition as well as the reps and/or conditions. Anyone's guess exactly what that means, but better to avoid the extra layer of confusion. Bottom line -- it's just style/semantics, but isn't changing the overall picture or making it seller friendly.
Posted by: Joe | Oct 3, 2007 8:18:45 AM