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Monday, October 8, 2007

SLM: Waiting for Thursday

SLM Corp. releases its third quarter results this Thursday, Oct 11.  For those eagerly watching SLM's dance with Flowers et al. and handicapping the possibility of a renegotiation or termination of SLM's deal to be acquired, it will likely provide further information to assess whether a material adverse change has indeed occurred to SLM.  In this regard, to the extent there is a settlement of this dispute, there are incentives on both sides to do so before release of this information. 

In the interim, I thought I would take a more in-depth look at the SLM argument that no material averse change occurred.  Since SLM has been relatively silent on the details, I'm going to rely upon the letter sent by QVT last Friday.  QVT makes two essential arguments, 1) no material adverse effect as defined in the the merger agreement occurred, and 2) if one did it is nullified by the MAE qualifers.

As an initial matter, QVT first makes hash of the Flowers group's position that:

The MAE is compounded by the dramatic changes in credit markets, changes that have a disproportionate impact on Sallie Mae, a company that has to raise tens of billions in the wholesale credit markets every year to fund its operations.

As QVT notes:

Indeed, a general financial disruption, such as the recent turbulence in the credit markets, is precisely what the customary language of this exception to the MAE is intended to cover.

Here QVT is referring to the exception in the MAC definition for: 

(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 . . . .

I think QVT is right.  Any change Flowers is asserting is picked up by the exclusion in (e) of the MAC definition.

The next point which QVT makes is that the disporportionality exclusion in (b) of the MAE definition excludes any MAE claim.  This excludes from an MAE:

(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 . . . .

QVT uses this provision to argue that:

[W]e doubt very much based on applicable Delaware precedent that a court will interpret the MAE clause actually negotiated to mean that if a change in applicable law is at all more adverse than what is set forth in your 10-K for the year ended December 31, 2006 (the" 1 0- K") then an MAE is deemed to have occurred, regardless of whether such incremental change is itself material. We think a court would instead read the clause as requiring that an event or change have a material adverse effect on Sallie Mae, with materiality judged from the baseline established by what was specifically known to the buyer and carved out in the contract.

QVT is arguing that clause (b) itself contained its own "material adverse effect" qualifier which requires that the disporpotionality of the change be itself materially adverse.  I'm not sure that I agree here with QVT.  This language was highly negotiated and only requires that:

the 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 . . . .

There is no materiality qualifier here.  It only requires that the proposal be adverse in any respect.  And SLM has already admitted that it estimates the bill is more adverse to core earnings over a five year period by 1.8%-2.1%.  A Delaware court will utilize the normal interpretation rules for contracts when interpreting this provision.  This will require it to enforce the plain meaning of the contract unless it is ambiguous.  If it is ambiguous the court will then look to the parties' intentions.  Here, I doubt a Delaware court would get past the plain reading of this highly-negotiated contract which requires that it only be more adverse. 

Moreover, even if QVC is correct and Flowers must prove an MAE over and above the "incremental impact of the provisions of the CCRA relative to the pending budget and legislative proposals that are referenced in the 10-K,"  QVC makes another fundamental error.   QVC measures this MAE on a net basis (i.e., they lump together the good and bad effects and take the net effect).  However, I believe a MAE is assessed based on the bad effects to the exclusion of the good.  After all this is what the parties are assessing.  I admit this is an open question under Delaware law, but this is my reading.  Moreover, here QVT conflates the disproportionate aspect of the proposal with whether a MAE did indeed occur.  For these purposes, SLM has still not disclosed the numbers necessary to make this calculation.  They have only stated that it would have a disproportional impact compared to the disclosure in the 10-K.  Thus, the jury is still out about whether an MAE has indeed occurred, though, the way the parties are acting it looks that way -- i.e., if SLM did not have an MAE it would disclose the numbers.

And this brings us back to QVT's argument that an MAE cannot not be established under the definition since it was contemplated by:

the legislative and budget proposals described under the heading 'Recent Developments' in the Company 10-K", not just the Bush budget proposals; many of the provisions that Flowers uses to claim that CCRA represents an MAE were already included in such legislative proposals . . . .

QVT is thus arguing that even if an MAE did occur it was largely contemplated in the Recent Developments Section of the 10-K  and therefore excluded. To analyze this let's set forth the disclosure:

RECENT DEVELOPMENTS

Student Aid Reward Act of 2007 On February 13, 2007, Senator Kennedy introduced the Student Aid Reward Act of 2007, which offers financial incentives to schools to participate in the Direct Loan Program. Under the bill, schools would receive payments from the government not to exceed 50 percent of the budget scored “savings” to the government as a result of the school using the FDLP rather than the FFELP. The bill provides that schools could use such payments to supplement the amount awarded to Pell Grant recipients or could use such payment for grants to low- or middle-income graduate students. Schools would be required to join the Direct Loan Program for five years from the date the first payment is made to qualify for the payments. Because payments would be contingent on available funding, schools switching from the FFELP to the FDLP would be paid first and, then, other FDLP schools, if funds remained, would be paid on a pro-rata basis.

President’s 2008 Budget Proposals On February 5, 2007, President Bush transmitted his fiscal 2008 budget proposals to Congress. The budget included several proposals that would reduce or alter payments to both lenders and guarantors in the FFELP. The specific proposals include: (1) reducing special allowance payments on new loans by 0.50 percentage points; (2) reducing the default guaranty from 97 percent to 95 percent; (3) reducing payments to Exceptional Performers by two percentage points; (4) doubling lender origination fee for FFELP Consolidation Loans, from 0.5 percent to 1.0 percent; (5) reducing collections retention to 16 percent beginning in fiscal 2008; (6) reducing administrative cost allowance payments to guaranty agencies, changing the formula from a percent of original principal to a unit cost basis; and (7) eliminating the Perkins loan program. If enacted in their current form, and the Company takes no remedial action, the FFELP programs cuts proposed in the President’s budget proposal detailed above, which are to be implemented prospectively, could over time have a materially adverse affect on our financial condition and results of operations, as new loans originated under the new proposal become a higher percentage of the portfolio.

Student Loan Sunshine Act In February 2007, the “Student Loan Sunshine Act” was introduced in both the House and Senate with the stated purpose of protecting student loan borrowers by providing them with more information and disclosures about private student loans. The bill applies to all lenders that make private educational loans through colleges and universities, as well as to lenders of direct-to-consumer educational loans. The bill’s provisions also apply to post-secondary educational institutions that receive federal funds. The legislation would impose significant new disclosure and reporting requirements on schools and lenders and would prohibit gifts with a value greater than $10 from lenders to financial aid professionals. The legislation would require schools to include at least three unaffiliated lenders on any preferred lender list. The legislation would amend the “Truth in Lending” Act to require lenders to notify the school if their student, or parent of their student, applies for a private education loan, regardless of whether the lender has an education loan arrangement with the school, and to require the school to notify the prospective borrower whether and to what extent the private education loan exceeds the cost of attendance, after consideration of all federal, state and institutional aid that the borrower has or is eligible to receive. If the Student Loan Sunshine Act is enacted in its current form, it could negatively impact the financial aid process and the timely disbursement of private education loans, including the efficiency of direct-to-consumer loans, for borrowers at post-secondary education institutions, all of which could adversely affect our results of operations. In addition, the bill could adversely affect the strategy under which our primary marketing point of contact is the school’s financial aid internal brand originations.

Student Debt Relief Act of 2007 On January 22, 2007, Senator Edward Kennedy (D-MA) introduced the Student Debt Relief Act of 2007 (S. 359) along with Senators Durbin (D-IL), Lieberman (D-CT), Mikulski (D-MD), Obama (D-IL), and Schumer (D-NY) as co-sponsors. The proposed legislation would, in addition to increasing Pell grants and providing other benefits to student loan borrowers, • once again allow in-school loan consolidation and allow “reconsolidation” of FFELP Consolidation Loans; • make charging Direct Loan origination fees subject to the discretion of the Secretary of Education; and, for borrowers with Direct Loans only, provide borrowers employed in public service with loan forgiveness after 120 payments under the income contingent repayment plan. The Student Debt Relief Act also contains the provisions of the Student Aid Reward Act of 2007 (see discussion below). If the Student Debt Relief Act becomes law in its current form, it could negatively impact the Company’s future earnings. College Student Relief Act of 2007 On January 17, 2007, the U.S. House of Representatives passed H.R. 5, the College Student Relief Act of 2007. The bill was principally designed to lower student loan interest rates paid by borrowers of subsidized undergraduate FFELP and FDLP loans over a five year period beginning July 1, 2007, from 6.8 percent to 3.4 percent in 2011. Because the lender rate is separate from the borrower rate, the interest rate cut does not affect lenders. The interest rate cut, however, does have a sizable budget effect because the federal government pays to the lender any positive difference between the lender rate and the borrower rate. To offset the additional budget cost, the legislation makes several changes to increase costs to lenders and guaranty agencies. The legislation would reduce default insurance from 97 percent to 95 percent, eliminate Exceptional Performer, double the lender origination fee on all new loans from 0.5 percent to 1 percent, reduce special allowance formula on all new Stafford, PLUS, and FFELP Consolidation Loans by 0.1 percent (exempting the smallest lenders) and increase the offset fee that consolidation lenders pay, to 1.3 percent for consolidation loan holders whose portfolio contains more than 90 percent FFELP Consolidation Loans. The legislation would reduce the amount that guaranty agencies may retain upon collecting on defaulted claim-paid loans. The legislation will be transmitted in the Senate, where it will be referred to the Senate Health, Education, Labor, and Pensions Committee and is unlikely to be considered as a stand-alone bill. The Senate HELP committee is expected to begin consideration of the Reconciliation of the Higher Education Act prior to its expiration in June and sections of H.R. 5 could be considered as part of that legislation. The Company has several loan pricing mechanisms, such as the level of Borrower Benefits, that would mitigate some of the negative impact of this proposal. Also, reduced profitability in the student loans could result in a number of our competitors leaving the industry which would benefit us. In addition, this legislation would be implemented prospectively, so its effect would gradually impact us over a number of years. Accordingly, we cannot predict the effect of this proposed legislation on the Company’s financial condition and results of operation.

[NB.  There is a bit more here but for the purpose of brevity it is omitted]

The Flowers group states in its own letter that:

Near the end of our negotiations, Senator Kennedy made a proposal that called for subsidy cuts deeper than the cuts described in the 10-K.  The company asked us to accept the risk that the Kennedy proposal would become law.  We refused.  We drew the final line -- the maximum pain we were willing to take -- at the Bush Budget Proposal.

Here I believe the Flowers group is incorrect.  The Recent Developments section of the 10-K does include a Kennedy proposal and is therefore included in the MAE exclusion (I am not sure if this is the one the Flowers group is referring to, but nonetheless it does include at least one Kennedy proposal).  [NB.  A reader subsequently wrote to say Flowers may be referring to the Kennedy proposal referred to in SLM's 10-Q filed on May 10, 2007). 

Nonetheless, to determine if QVT is right, the question comes down to whether the current Bill as enacted was contemplated in the Recent Developments section.  All of the representations and warranties in the heading of Article IV are qualified by the disclosure in the 10-K (excluding the Risk Factors).  The MAE that the buyers are claiming is a breach of the representation is in Section 4.10.  QVT is thus likely arguing here that the Recent Developments section qualifies this MAE even though it was not specifically contemplated in the MAE definition.  This is an interesting argument because I doubt the parties intended it:  clearly the MAE definition was meant to be bargained for as an independent being.  But still, a court could adopt a literal reading of the agreement and find that this risk factor qualifies the MAE representation.  And if it finds it contemplated the new budget proposal was at least partially disclosed in the 10-K it could mean that QVT is right and these elements need to be excluded out of the MAE to determine if an MAE even occurred.  Food for thought. 

Otherwise, with this exception I still believe that an MAE here likely occurred.  And of course, this is only the legal case.  The $900 million reverse termination fee changes the negotiating calculus substantially. 

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