Sunday, November 18, 2007
The Genesco/Finish Line material adverse change dispute is now about as ugly as it gets. First, early last week Genesco filed an amended complaint. The amended complaint was largely unremarkable and unchanged from the original, although in addition to a specific performance claim, Genesco amended its complaint to include an alternative claim for damages relief (this is important -- I'll get to it below under the heading Solvency). Later in the week, Finish Line answered. Finish Line, now having the benefit of discovery, counter-claimed "against Genesco for having intentionally, or negligently, misrepresented its financial condition in order to induce Finish Line into entering" the transaction. Shifting tactics, Finish Line also baldly asserted that a material adverse change had occurred to Genesco under the terms of the merger agreement. Moreover, Finish Line asserted that "[t]his fundamental change in Genesco's financial position also raises serious doubts that Finish Line and the combined company will be solvent following the Merger." Finish Line concluded its answer and counter-claim by stating:
As a result, Finish Line suffered injury by entering into the Merger Agreement while unaware that Genesco was in the midst of a financial free-fall, for which there still appears to be no bottom.
It actually got worse after this. On Friday, UBS counter-claimed in the Tennessee Court. UBS didn't assert a claim of "intentional, or negligent, misrepresentation". Instead they threw down a counter-claim of fraud against Genesco. Things are real bad when your ostensible banker is accusing you of fraud. Not content with that charge, UBS also sued both Finish Line and Genesco in the Southern District of New York seeking to void its financing commitment letter since Finish Line could not deliver the solvency certificate required to close the financing. The reason UBS asserted was that "[d]ue to Finish Line's earnings difficulties and Genesco's disastrous financial condition, the combined Finish Line-Genesco entity would be insolvent . . . . " Clearly, Finish Line's specially hired uber-banker Ken Moelis was unable to perform his expected job of reigning in UBS. [update here is the UBS N.Y. complaint]
This is a mess.
Material Adverse Change Clause
First, the material adverse change issue. My first thought is that this case is a very good example of the fact-based nature of MAC disputes. When we first looked at this deal back on August 31, I noted that I thought Genesco had a good legal case based on the tight MAC clause it had negotiated. But I also stated that my conclusions at that time were based on the public evidence and that discovery would flesh out the validity of Finish Line's claims. It now appears that Finish Line's claim is premising its MAC claim on Genesco's earnings drop -- a decline of 100% to $0.0 earnings per share compared to the same period from the previous year when Genesco's earnings per share were $0.24.
As we know under Delaware law a "short-term hiccup in earnings should not suffice; rather the Material Adverse Effect should be material when viewed from the longer-term perspective of a reasonable acquiror." In re IBP, Inc. Shareholders Litigation (“IBP”), 789 A.2d 14 (Del. Ch. 2001). Thus, it is interesting to note that Finish Line's only support for this assertion appears to be the following:
What is more, there is no indication Genesco's decline has bottomed out. Genesco's most recent financials instead indicate that it is poised to suffer another substantial drop in earnings in the third quarter.
Finish Line still hasn't factually asserted anything longer term than two quarters of adverse performance. Thus, to the extent the Tennessee court adopts Delaware law on this issue, Finish Line is going to have to show at trial that this is an adverse change that is going to continue. They have a good start with the two-quarter drop, if indeed Genesco's results announced later this month show such a drop, but at trial Finish Line will still need to prove the long term nature of this change. Moreover, the MAC clause in the merger agreement excludes out a failure to meet projections as well as:
(B) changes in the national or world economy or financial markets as a whole or changes in general economic conditions that affect the industries in which the Company and the Company Subsidiaries conduct their business, so long as such changes or conditions do not adversely affect the Company and the Company Subsidiaries, taken as a whole, in a materially disproportionate manner relative to other similarly situated participants in the industries or markets in which they operate;
Nowhere does Finish Line comprehensively address this argument. My bet is, given the of-late poor performance of Finish Line itself, the definitive MAC issue at the Tennessee trial is going to revolve substantially around whether this sub-clause (B) excludes out any MAC. Here, note the materially disproportionate requirement, something notably absent in the SLM/Flowers MAC (to their detriment). Thus, Finish Line still has a high hurdle to meet in order to prove a MAC-- it must prove the long term nature of this claim beyond two quarters and that it is materially disproportionate to what is occurring in the industry generally.
Perhaps as a comment on the Finish Line MAC claim, UBS in its own complaint makes the following statement about the Material Adverse Change to Genesco:
UBS denies that there necessarily has been no Material Adverse Effect with respect to Genesco's business.
UBS has yet to claim a MAC occurred in the merger agreement. And, I have not read UBS's N.Y. complaint but it appears that they have not asserted the mirror-image MAC clause in their financing commitment letter to justify not financing the deal. Rather, their argument appears centered on fraud by Genesco and the insolvency of the combined entity.
The one monkey-wrench here is the solvency claim which may in and of itself justify a MAC claim.
The issue had been rumored on the Street for a while, but still the solvency claim is amazing. Finish Line is clearly frantically trying to avoid a doomsday scenario where it is required to complete the Genesco deal but lacks the financing to do so. Thus, Finish Line claims that "[t]he ability of Finish Line and the combined enterprise to emerge solvent from the Merger is an additional condition precedent to the Merger Agreement under Sections 4.9 and 7.3." However, Section 4.9 is Finish Line's own representation to Genesco as to its solvency post-closing. Section 7.3 is the condition that Finish Line's own representations must be true in order for Finish Line to require Genesco to close. But, Genesco can waive this condition and the breach of this representation! Moreover, Finish Line appears to be aware of this snafu; so it also claims that if the post-combination company is insolvent it would violate Genesco's representation in 3.17 that the merger will not violate any law applicable to Genesco. I think this final argument is a stretch -- the violative conduct would be that of Finish Line -- if the parties had wanted to pick up this type of conduct they would have had Genesco make the representation rather than Finish Line.
Still, any judge would be loathe to order specific performance of a merger that would render the other party insolvent -- which is why I suspect Genesco is now asking for a monetary award. This is an alternative to this issue. Nonetheless, I want to emphasize that any judge in the face of this insolvency may find it to be MAC. I don't believe that this is what the MAC is intended to encompass or that the plain language is designed to address such events -- it is merely changes to Genesco. If the parties had wanted they could have negotiated a solvency condition. But they didn't. Nonetheless, the event is so horrific a judge may find a way to read the MAC clause this way.
The bottom line is that even if this combination would indeed render Finish Line insolvent, I'm not sure they get out of this agreement unless the judge stretches in interpreting the MAC clause. There is no specific solvency condition and the agreement does not contain any specific out for such circumstances.
Unfortunately for Finish Line, UBS has a better case to escape its financing commitments. Under the financing commitment letter, it is a condition to closing that UBS receive:
all customary opinions, certificates and closing documentation as UBS shall reasonably request, including but not limited to a solvency certificate.
If the combined company is indeed going to be insolvent UBS can get out of its financing commitment. But as I've said, it is unclear if Finish Line can also get out of its own agreement. Given this, Finish Line must clearly be desperate to raise this issue in its own filings. But I suppose it has nothing to lose at this point.
It is at this point that I will quote Finish Lines representation at Section 4.6:
For avoidance of doubt, it shall not be a condition to Closing for Parent or Merger Sub to obtain the Financing or any alternative financing.
While I tut-tut the lawyers for putting this as a representation (it is more appropriate to include as a covenant or in the conditions to closing), it bears repeating that there is no financing condition in this merger agreement.
As an aside, in Section 6.9 Finish Line agrees that:
In the event any portion of the Financing becomes unavailable on the terms and conditions contemplated in the Commitment Letter, Parent shall use its reasonable best efforts to arrange to obtain alternative financing from alternative sources in an amount sufficient to consummate the transactions contemplated by this Agreement on terms and conditions not materially less favorable to Parent in the aggregate (as determined in the good faith reasonable judgment of Parent) than the Financing as promptly as practicable following the occurrence of such event but in all cases at or prior to Closing. Parent shall give the Company prompt notice of any material breach by any party to the Commitment Letter of which Parent or Merger Sub becomes aware or any termination of the Commitment Letter. Parent shall keep the Company informed on a reasonably current basis in reasonable detail of the status of its efforts to arrange the Financing.
This doesn't mean particularly much for Genesco as there is no way that any bank is going to give financing to Finish Line on the same terms as UBS has. Any financing will be much less favorable, so Genesco can't get much from this. I note this only as a possible rabbit hole.
The fraud claim by UBS and intentional or negligent misrepresentation claim by Finish Line are much more interesting. Finish Line alleges that:
On top of this, by its own admission, Genesco also knew by at least early June that its second quarter projections were based on the erroneous assumption that certain state's back-to-school dates and tax holidays fell during the second quarter. Despite this, Genesco intentionally, or negligently, failed to provide Defendants, prior to execution of the Merger Agreement, with its May operating results or tell Defendants that Genesco's second quarter projections mistakenly relied on certain back-to-school dates and tax holidays occurring in the quarter.
UBS's fraud claim relies on similar non-disclosure.
I'm going to wait and see Genesco's response before responding to this as it is a pure question of fact. If the court finds this true, it would generally justify excusing Finish Line's performance. The New York law on this is actually more developed -- I am not sure off-hand what the Tennessee law is. Again, though, this is really just something that will depend on how each judge rules. Ultimately since the Tennessee judge is ruling first, the New York one will likely follow.
But I will say this, Finish Line clearly wants out of this agreement at all cost and is playing a scorched earth policy. It has now completely alienated the employees and officers of a company it may have to acquire. Quite a risk and perhaps why they did not allege fraud but rather negligent misrepresentation (though again I am not up on Tennessee law on this point so there may be real differences and reasons for this -- I'll look into it).
The bottom-line is that this deal still has a long way to go before it closes. Although Genesco still has a decent defense against a MAC claim, the solvency and fraud claims could still strongly work to Finish Line's favor. This is something we just don't know until we see Genesco's response, and even then much of this will be determined at trial as a question of fact. Also, do not forget that even if Genesco wins in Tennessee, there is still now a New York action to face (and UBS can further amend its complaint there to litigate a MAC claim under N.Y. law in the financing commitment letter). This may ultimately be Finish Line's problem but still has the potential to mean no deal for Genesco or a damages remedy it can only enforce in bankruptcy court (Finish Line's bankruptcy that is) if Finish Line is unable to enforce its financing commitment. Of course, the lawyers could have avoided this final complexity by siting the choice of forum clauses in the financing commitment letter and the merger agreement in the same states. M&A lawyers should take note.
Ultimately given the risks, if I was Genesco the good business decision would be to settle this out for a lump sum payment -- but the parties appear too intractable at this point for such a disposition. Though there is a very real scenario here where Genesco actually ends up controlling Finish Line -- talk about payback.