Tuesday, October 16, 2007
The Flowers consortium filed their answer and counter-claim yesterday in Delaware Chancery Court. The Flowers group counter-claim boils down to a request that the Chancery Court declare that a Material Adverse Effect under the merger agreement with SLM has occurred and that it will be continuing at the time of closing such that Flowers et al. are excused from performance (and paying the $900 million termination fee). This dispute is no longer over whether a deal will be reached -- I think it has devolved into a battle over the $900 million. And after reviewing Flowers et al.'s counter-clam, I continue to believe that they have made a good legal argument that a MAC under the merger agreement definition has occurred. I might add they are following the exact legal arguments I predicted in my prior post here. So, let's begin. The relevant portions of MAC definition in the merger agreement are:
"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: . . . . (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; . . . . (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 . . . .
As an initial matter, Flowers attempts to establish that a "material adverse effect" has occurred. This is the initial requirement under the MAC definition. Flowers et al. state that the recently enacted legislation:
Will cut subsidies to the student loan industry by $22.32 billion over the next five years on a present discounted value basis, and that will cut Sallie Mae’s core income by approximately $316 million, or 15.2% in 2009, rising to a reduction of approximately $595 million, or 23.%% in 2012, as compared to reasonable projections of Sallie Mae’s core net income if the new legislation had not been enacted . . . .
This is the first real quantification of the ultimate effect of this legislation I have seen. To my knowledge, SLM itself has refused to quantify the aggregate impact of this legislation. Instead to date, SLM has only stated that the legislation will have an aggregate adverse impact of 1.8%-2.1% to core earnings over the next five years over above the total impact of the legislation disclosed in the recent developments section of their 10-K. 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. If the Flowers group is correct in their assessment of the detrimental effects, this high bar would likely be met. This could explain why SLM does not argue that there was no "material adverse effect" under the above definition in its own complaint but instead argues that a MAC is barred due to application of one of the exclusions in the definition.
The Flowers group must not only meet their burden of proving that a material adverse effect has occurred, they must show that one of the exclusions above in the MAC definition are not applicable. Here, Flowers first addresses clause (b) -- the "changes in applicable law" exclusion. Remember from my prior post, SLM is arguing that:
the “enacted legislation is entirely excluded from consideration as an MAE unless it is more adverse to Sallie Mae than the” proposals disclosed in the Recent Developments Section of the 10-K. Furthermore, SLM argues that any adverse enacted legislation must be considered in comparison to these proposals. SLM then concludes by asserting that only if the difference between the proposals and the enacted Bill is a material adverse effect with respect to the “totality” of the “financial condition, business, or results of operation” of SLM and its subsidiaries is it not excluded from the definition of MAC.
The Flowers group counters with the same argument I made in my post. Namely on its face the plain language of the MAC definition requires that the enacted legislation be only adverse -- there is no materiality qualifier. The Flowers group states:
The exception is limited however. If a “change in Applicable Law” is “in the aggregate more adverse” to Sallie Mae than the proposals described in the Sallie Mae 10-K, then the new legislation is not a “change in Applicable Law” that is excluded from consideration in evaluating whether there has been a Material Adverse Effect. Accordingly, “changes in Applicable Law” that are in the aggregate more adverse to the company than the proposals described in the Sallie Mae 10-K must be considered in determining whether there has been a Material Adverse Effect.
Flowers then asserts that since this is the plain language of the contract, the court need look no further. Here, I agree. Basic contract interpretation rules require the court to look first to the plain language of this contract. And here the language negotiated by these highly sophisticated parties is clear that it need only be adverse. Nonetheless, the Flowers group makes a strong case in their counter-claim that even if parole evidence (evidence outside the contract) is considered, the parties specifically considered the second Kennedy proposal for inclusion in the MAC definition exclusions and rejected this consideration. The Flowers group states:
On April 14, 2007, after learning the published details of the Kennedy Proposal, Mustang again revised Sallie Mae’s Material Adverse Effect definition, reiterating that Mustang would only accept the risk of enactment of those proposals that were described in the Sallie Mae 10-K, e.g., excluding the Kennedy Proposal, and that Mustang would not accept the risk of any legislation “more adverse” to the Company. During the discussion on April 14, 2007, the parties agreed that the Kennedy Proposal, if enacted, would not be subject to the “changes in Applicable Law” carve-out from the definition of Material Adverse Effect. The Material Adverse Effect language was finalized on April 15, 2007, with Mustang adding language to ensure that the carve-out for the proposals in the Sallie Mae 10-K was for those proposals in the form posed publicly as of the date of the Company 10-K, i.e. March 1, 2007.
While SLM will obviously have a different story, the Flowers group's argument is supported by the fact that the second Kennedy proposal was disclosed in SLM's April 10 10-Q filed just before the merger agreement was announced. The parties could have specifically included this proposal but did not.
Finally, the Flowers group argues that a material adverse effect has also occurred due to a separate 4.9% decline in core earnings for SLM resulting from the current credit crunch. Moreover, the Flowers group argues that the adverse effect is not excluded by clause (e) above -- "general industry changes" because:
While current market conditions have had a negative effect on most financial institutions, the collapse of the securitization market and disruption of the asset-backed commercial paper market have “disproportionately affect[ed]” Sallie Mae relative to similarly sized financial services companies” and this are not excluded from the Merger Agreement’s definition of Material Adverse Effect . . . .
I'm not sure this is a winner. The 4.9% adverse effect is below the 5% materiality threshold for GAAP and, although there is little case law on this, to establish a MAC it is generally thought that the effect to earnings must be significantly higher. Moreover, the general exclusion here is likely to absorb much of this claim. So, I think the Flowers group is keeping this in for form but has a much better claim based on the enacted legislation.
Bottom Line: Obviously, this is all based on the public information and more will come out prior to trial, but as of now, I believe that the Flowers group has a solid claim that a MAC occurred under the merger agreement and that it is not excluded. I think this is particularly true given the quantification of the impact on SLM and the evidence that the second Kennedy proposal was considered and excluded from the MAC definition. The latter point is particularly problematical for SLM because it argues strongly against their own argument that a materiality qualifier should be written into the applicable law exclusion. If this is true then why was the second Kennedy proposal specifically excluded by the parties from the MAC definition?
Final Note: As I stated yesterday on the expedited relief SLM has requested:
I think Flowers makes a good point that this is now only about the $900 million and they are willing to fight it out by permitting SLM to terminate the merger agreement without prejudice. This would alleviate SLM's need for expedited relief. Still, I think the judge on this matter, Vice Chancellor Strine, will grant the request to expedite as it will mean a trial and opinion is more likely. This is a prominent case and Strine will not only want to put his name on another notable opinion, but he has incentives to maintain Delaware as the more certain law on these adjudications by doing so (this will mean more companies choosing Delaware law and forum to adjudicate these disputes). Plus Strine wrote the opinion in IBP v. Tyson, the last big MAC case, and he will likely want to take the opportunity to flesh out the law on that opinion. From my perspective, this is a good thing as we could use more case law on the interpretation of the exclusions from a MAC definition.
On further reflection, I continue to think this is the way things will go. There is a meeting in Strine's chambers next Monday at 1:00 p.m. on scheduling. We will have more information then.