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Editor: Brian JM Quinn
Boston College Law School

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Thursday, October 25, 2007

Harman: Bad to the Bone

Well, not surprisingly Harman waited the maximum four business days allowed under the Form 8-K rules to file the agreements related to its settlement with its former purchasers, KKR and GSCP.  Here they are:

Termination and Settlement Agreement

Indenture for $400 million Notes

First, the settlement agreement.  And once I started reading, it didn't take long for me to be shocked.  Right there in the recitals the agreement states:

WHEREAS, Parent and Merger Sub have determined that they are not obligated to proceed with the Merger based on their belief that a Company Material Adverse Effect has occurred and their belief that the Company has violated the capital expenditures covenant in the Merger Agreement.

WHEREAS, the Company steadfastly denies that a Company Material Adverse Effect has occurred or that the Company violated the capital expenditures covenant in the Merger Agreement.

I had heard street rumors that Harman had allegedly violated the cap ex requirement in their merger agreement but I had refused to believe it as too far-fetched.  Nonetheless, there is hte allegation (underlined).  But to see why I am so schocked, let's take a look at the actual cap ex requirement in Section 5.01(b)(vi) of the Harman merger agreement.  It requires that Harman shall not:

(vi) make any capital expenditures (or authorization or commitment with respect thereto) in a manner reasonably expected to cause expenditures (x) to exceed the capital expenditure budget for the 2007 fiscal year previously provided to Parent or (y) for the 2008 fiscal year to exceed the 2008 capital expenditure budget taking into account reasonably anticipated expenditures for the balance of the year as well as expenditures already committed or made (assuming for this purpose that fiscal 2008 capital expenditure budget will not exceed 111% of the fiscal 2007 capital expenditure budget);

This is a bright line test.  Typically, right after the merger agreement is signed the M&A attorneys will sit down with the CFO and other financial officer and point this restriction out (actually these officers are also involved in the negotiation of this restriction since this is their bailiwick).  Since there is a set dollar amount in this covenant it is very easy to follow and thus for a company not to exceed its dollar limitations.  The CFO or other financial officer simply puts in place systems to make sure that the company does not violate the covenant by spending more than that amount.  This is no different than my wife telling me I can't spend more than $500 this month on entertainment.  It is a direction I can easily follow and I know there are consequences if I do not (Oh, and I do follow it).  This is no different here -- a violation of the cap ex covenant provides grounds for the buyers to terminate the agreement.  But this is and should be a problem for sellers.

Because of all this, if your attorneys have done their job and informed you of this covenant and included you in its negotiation, to violate it is really just plain old gross negligence.  And such a violation is just the allegation made by the buyers here.  Harman denies them, but if it is true people should be fired over this.  Also expect the class action attorneys to amend their pending suits to include this claim to the extent it is not already in there. 

I also spent a fair bit of time this morning trying to work out the value of these $400 million notes.  To do so you need to add on the value of the option to convert the notes into Harman shares.  The formula in the indenture for this conversion is a bit complicated, so I want to check my math.  It is also an American option so Black-Scholes can't be used.  In any event, I'll post my back of the envelope calculations tomorrow.  If anyone else does this exercise, send me your results and we'll cross-check. 

Also note that the Indenture has a substantial kicker in Section 10.13(c) if there is a change in control in Harman.  That is a nice bonus:  lucky limited partners of KKR and GSCP. 

The notes were purchased as follows:

KKR I-H Limited $ 171,428,000.00

GS Capital Partners VI Fund, L.P. $ 26,674,000.00

GS Capital Partners VI Parallel, L.P. $ 7,335,000.00

GS Capital Partners VI Offshore Fund, L.P. $ 22,187,000.00

GS Capital Partners VI Gmbh & Co. KG $ 948,000.00

Citibank, N.A $ 85,714,000.00

HSBC USA, Inc. $ 85,714,000.00

But Citibank and HSBC have quickly hedged (really disposed of) their ownership risks and benefits under the notes per the following language in the Form 8-K:

Concurrently with the purchase of the Notes by Citibank and HSBC, each of them entered into an arrangement with an affiliate of KKR pursuant to which the KKR affiliate will have substantial economic benefit and risk associated with such Notes

And for those who love MAC definitions (who doesn't), just for fun I blacklined the new definition in the note purchase agreement against the old one in the merger agreement.  Here it is:

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 Mergertransactions contemplated by the Transaction Agreements, 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 ) to the extent resulting from the determination of KHI Parent has expressly requested or to which Parent has expressly consented; (iv) to the extent resulting from the announcement of the Inc. and KHI Merger Sub Inc. that they were not obligated to proceed with the merger under the Merger or the proposal thereof or this Agreement and the transactions contemplated herebyAgreement or any of the facts or circumstances underlying that decision, including any lawsuit related thereto (including the pending putative class action in the Federal District Court in the District of Columbia) or any loss or threatened loss of or adverse change or threatened adverse change in, in each case resulting therefrom, in the relationship of the Company or its Subsidiaries with its customers, suppliers, employees, shareholders or others; (iv) resulting from actions of the Company or any of its Subsidiaries which a Sponsor or any of their Controlled Affiliates has expressly requested or to which a Sponsor or any of their Controlled Affiliates has expressly consented; (v) to the extent resulting from the announcement of the termination of the Merger Agreement, the purchase of the Notes pursuant to this Agreement, or the proposal thereof, or this Agreement or the Termination and Settlement Agreement and the transactions contemplated hereby or thereby, 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; (vi) 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 (vi) 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) i) 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. 

Note the addition of a litigation exclusion for the pending shareholders class actions.  Smart move.

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