Thursday, September 13, 2007
I'll be on hiatus this Thursday (Sept 13) and Friday (Sept 14) returning Monday (Sept 17). In the meantime, you may find interesting the Wall Street Journal Deal Journal post on my Applebee's post. Apparently, Applebee's refused to comment on the one and a half month gap between the announcement of the agreement and disclosure of its split board.
Wednesday, September 12, 2007
By now most of you have probably read that Applebee's last week disclosed in its preliminary proxy filing that its board split 9-5 in favor of being acquired by IHOP. The dissenters included the current and former CEOs of IHOP. The history is worth a full read as it reveals Applebee's consideration and rejection of a stand-alone plan involving a recapitalization and special dividend and that IHOP reduced its offering price from $27.50 to $25.50 as a result of its due diligence on Applebee's.
What I think is the more troubling here is a Applebee's failure to disclose this split vote until about a month and a half after it agreed to the transaction. I think that you could make a good claim that Applebee's failure to do so was a material omission in violation of the federal anti-fraud rules. If I am a shareholder purchasing shares post-transaction announcement, I would think I would find this significant in the total mix of information. After-all, this fact would have significance to many shareholders in making their vote.
You could quibble with this point, but I think that in a post-Dura Pharmaceuticals v Broudo, 544 U.S. 336 (2005) world Applebee's has almost no liability exposure if indeed the fact is material. Dura held that a plaintiff could not establish loss causation under Rule 10b-5 by proving that the price on the date of the purchase was inflated because of the misrepresentation. Rather, a plaintiff must show an actual loss such as a share price fall related to the misstatement. In the case of Applebee's, to establish loss causation in a post-Dura world a plaintiff would have to show that there was a share price movement triggered by Applebee's disclosure of this fact in its proxy statement filing. The problem, though, is two-fold. First, the Applebee's share price is anchored by the IHOP offered price. This isn't likely a foreclosing problem under Dura, though, as the trading of Applebee's stock would still likely be affected to some extent due to a reassessment of the chances of the deal collapsing. Rather, the actual problem is that the institutional shareholders and proxy advising agencies will not make their recommendations and take positions until closer to the vote, and certainly will not on the day the proxy statement is filed -- they need time to read and analyze it. A more significant change in the Applebee's share price will not come until that assessment is completed and disclosed and shareholders have more information on their respective positions. Under Dura loss causation for failure to disclose this information at the time of the transaction announcement would therefore be almost impossible to establish. Yet, these institutional shareholders and proxy services will likely base their decision on this split vote. Of course, if the shareholders then vote to disapprove the merger, the share price will move even more then, but again, loss causation will be even closer to impossible to prove for this ommission.
I admit there are a number of assumptions underlying my statements above, and that I make one double materiality assumption (i.e., the information is material to the instit shareholders and proxy services and their voting decisions are material to other shareholders). Nonetheless, my main point here is that post-Dura the incentives to disclose material information early in takeover transactions appear to be shifted to permit more leeway towards non-disclosure. This likely exacerbates the traditional problems with disclosure in the history of the transaction section of takeover documents. This section is often the most carefully drafted portion of the takeover document; it is written to gloss over or spin problems which arose during the transaction negotiation, and often management will put strong pressure on the lawyers to make judgments about materiality which exclude seemingly important facts. The SEC review process often picks up on some of these problems and corrects them, but this review is limited at best. The interesting development is that, in this void, the Delaware courts have rapidly become the guardians for good disclosure. In NetSmart, Lear and other recent Delaware cases the Chancery Court has been quick to enjoin transactions under Delaware law for failure to disclose material information about the history of the transaction. This is attributable to the active role in takeovers by Delaware, compared to the quiescent one of the SEC (in contrast to other areas of securities law, the SEC has since the 1990s abstained from active regulating in the takeover arena). It is also due to the discovery power in litigation that plaintiffs have in the Delaware courts -- they can find these non-disclosed facts. It is clearly symbolic that the Delaware courts are increasingly enforcing the disclosure obligations of participants in takeovers -- something which historically has been the SEC's sole regulatory turf. For more on this see my forthcoming Article, The SEC and the Failure of Takeover Regulation.
Tuesday, September 11, 2007
Yesterday, Stark Investments converted its Schedule 13G with respect to Accredited Home Lenders into a Schedule 13D. A Schedule 13D is required to be filed by any person or entity who holds greater than 5% of a publicly traded issuer. The switch to a 13D is required whenever a previously passive investor changes their intentions with respect to control of the issuer. Stark's letter is great reading, and I set it out in full as it again highlights the bind Lone Star is in. Although their letter is a bit over-dramatic, I also tend to agree with Stark's fears that Accredited is likely to cut a deal with Lone Star despite Lone Star's relatively weak case. Accredited's directors are likely to prefer the certainty of a lower deal versus the risk (however minute) that the Delaware court will rule against it, a decision they have substantial latitude to make since it is likely reviewable under the business judgment rule. The letter is also yet more ammunition for those advocating the benefits of hedge funds as valuable shareholder activists. Here it is:
Ladies and Gentlemen:
Stark Investments and its affiliated investment funds (collectively, “Stark”) hold approximately 8.2% of the outstanding common shares of Accredited Home Lenders Holding Co. (“Accredited”). Based upon publicly available information, Stark appears to be Accredited’s second largest shareholder. We are writing with respect to the Agreement and Plan of Merger dated June 4, 2007, as amended June 15, 2007 (the “Agreement”), with Lone Star Fund V (U.S.), L.P. and its affiliates (collectively, “Lone Star”) and the related litigation pending in the Delaware Chancery Court.
On August 30, 2007, Lone Star publicly disclosed that it had made an offer to the Accredited Board of Directors to reduce the purchase price under the Agreement from $15.10 to $8.50 in exchange for resolving the pending litigation between Lone Star and Accredited. We believe that this offer is nothing more than an attempt to divert attention from the inherent weakness in Lone Star’s litigation position under the Agreement. Based on our review of the Agreement, it is evident that Accredited endeavored to obtain, and did successfully negotiate, unambiguous terms preventing Lone Star from terminating the Agreement based upon the changes in Accredited’s operations or financial condition that have occurred since execution of the Agreement. We read the express language of the Agreement as being clear that Lone Star assumed the entire risk of a diminution of value of Accredited in the present circumstances. The fact that these terms were obtained from a seasoned and sophisticated buyer of troubled assets, which was advised by a law firm that is a recognized expert in advising parties to merger and acquisition transactions, is clear evidence of Lone Star’s unqualified desire and intent to acquire Accredited while assuming the aforementioned risk.
We are pleased that the Board of Directors recognizes the strength of Accredited’s position under the Agreement and has rejected Lone Star’s revised offer. We support this decision and offer our support to the Board of Directors as it continues to appropriately carry out its fiduciary duties, which duties, in our view, require Accredited to pursue all available remedies under the Agreement. The strong protections included in the Agreement were designed to benefit and protect Accredited and its shareholders in circumstances such as those now faced by Accredited, and should be used accordingly.
We believe that the greatest risk now faced by Accredited’s shareholders is neither the possibility of further deterioration of the non-prime residential mortgage loan market in which Accredited competes, nor the risk of an adverse outcome at trial. The first risk was eliminated when Lone Star signed the Agreement and a proper application of the facts and law by the Delaware Chancery Court should eliminate the second risk. Instead, we believe that the greatest risk facing Accredited’s shareholders is that the Board of Directors will attribute too much significance to the unlikely possibility of an adverse outcome at trial and settle for a price far removed from the value of Accredited’s existing claims against Lone Star.
After a thorough review of the Agreement, the facts in the public domain (including the prevailing market conditions at the time the Agreement was executed) and relevant case law, we believe that the Delaware Chancery Court will see this case as we see it – an experienced and sophisticated buyer (with a long history of successfully stepping into adverse industry environments, purchasing companies or assets at distressed prices and reaping significant rewards when recovery occurs) that is now trying to back away from a transaction and the risks it explicitly agreed to assume, when it appears to have concluded that its timing was inopportune in this instance. Moreover, Delaware courts require parties such as Lone Star to meet a heavy, and we believe insurmountable here, burden of proof when attempting to terminate obligations in reliance upon material adverse effect (“MAE”) clauses of the nature contained in the Agreement. When Lone Star agreed to acquire Accredited, it did so after a long due diligence exercise and a multi-bidder process that Accredited detailed in its Schedule 14D-9, filed with the Securities and Exchange Commission on June 19, 2007. There can be little question that Lone Star was aware prior to signing the Agreement of the impact already being felt by Accredited as a result of existing and ongoing adverse market conditions.
As Accredited’s second largest shareholder, we fully support and encourage the Board to continue to make decisions consistent with the strength of Accredited’s legal position. It appears that we are certainly not alone in this assessment. Given that the trading price of Accredited’s common stock on the New York Stock Exchange has been materially in excess of $8.50 since the announcement of Lone Star’s offer on August 30, 2007, we believe the market also recognizes the weakness of Lone Star’s position and is anticipating a recovery well in excess of today’s closing price of $10.14. Given the significant number of Accredited’s shares that have changed hands over the past few trading days, any shareholder that does not agree with the strength of Accredited’s position has had ample opportunity to sell its shares at levels far exceeding Lone Star’s proposed amended price. Accordingly, we believe that the current shareholder base is strongly supportive of Accredited’s decision to enforce the Agreement’s terms and to pursue all available remedies thereunder. Please note that we currently expect to include a copy of this letter with the Schedule 13D filing that we plan to make next week. We are available to discuss these matters with you at your convenience.
Very truly yours,
/s/ Brian J. Stark
Brian J. Stark Principal
cc: Mr. Len Allen
Lone Star U.S. Acquisitions
It has now been almost two weeks since Genesco reported its second quarter earnings and its agreed acquirer, Finish Line promptly issued a statement that it was "evaluating its options in accordance with the terms of the merger agreement." Finish Line's statement appeared to raise the issue that Genesco's second quarter earnings are a material adverse change under the merger agreement. As I posted at the time, the impetus for this statement may also be a case of buyer's remorse. According to one report, "the deal had come under heavy fire from analysts and investors, who said Finish Line had offered too high a price and was taking on too much debt." Someone probably needs to send their financial advisers a copy of Bernard Black's classic Bidder Overpayment in Takeovers.
Since that time Genesco has not made any public statement on Finish Line's press release. Nor has Finish Line made any subsequent statements. The special meeting of Genesco's shareholders to vote on the acquisition is to be held on September 17. In the meantime, there is a heavy discount on Genesco's shares which closed yesterday at $45.50 compared to the $54.50 Finish Line has agreed to pay. The market is predicting a lower price or a broken deal [NB. I'm a little surprised at the large discount given the apparently weak case of Finish Line based on publicly available information]. Meanwhile, the deal parties are on radio silence.
The silence here is typical of MAC negotiations in public deals which tend to go on behind closed doors without public signaling to shareholders. A recent example is the Radian/MGIC negotiations which led to an abrupt and unexpected termination of the deal. I can see the benefits of this approach -- it permits rational, closed door business negotiations without play-by-play announcements which could result in wild fluctuation of the target's price, not to mention potential liability exposure. Nonetheless, if you were a shareholder of Genesco right now you'd be more than a little uncomfortable. A brief statement by Genesco of the status of nay negotiations would likely go a long way to assuaging this concern and better price Genesco's stock in the market. There are benefits to a continuous disclosure regime.
Addendum: The Genesco merger agreement contains the following clause which contractually limits public communication:
Section 6.9 Public Disclosure. The initial press release concerning the Merger shall be a joint press release and, thereafter, so long as this Agreement is in effect, neither Parent, Merger Sub nor the Company will disseminate any press release or other public announcement concerning the Merger or this Agreement or the other transactions contemplated by this Agreement to any third party, except as may be required by Law or by any listing agreement with the Nasdaq National Market, NYSE or CHX, without the prior consent of each of the other parties hereto, which consent shall not be unreasonably withheld; provided, however, that Parent’s consent will not be required, and the Company need not consult with Parent, in connection with any press release or public statement to be issued or made with respect to any Acquisition Proposal or with respect to any Change in Recommendation. Notwithstanding the foregoing, without prior consent of the other parties, the Company and Parent (a) may communicate with customers, vendors, suppliers, financial analysts, investors and media representatives in the ordinary course of business in a manner consistent with its past practice and in compliance with applicable Law and (b) may disseminate the information included in a press release or other document previously approved for external distribution by the other parties hereto.
It is not as restrictive as you think because it exempts out statements required by law or by the party's exchange listing agreement or with the consent of the other party (not to be unreasonably withheld). To circumvent this provision lawyers typically advise their clients that, in their reasonable belief, federal securities disclosure rules require the statement. The party opposing the communication cannot really do anything -- no court is likely to penalize a party for complying with the federal securities laws based on the reasonable advice of their lawyers. Here, Genesco can take the position that it must make a statement to correct prior disclosure -- a position which has the virtue of likely being correct.
Robert Miller over at Truth on the Market has an excellent post up on the recent Second Circuit decision in Merrill Lynch & Co., Inc. v. Allegheny Energy, Inc. The case revolves around the sale by Merrill Lynch of its energy trading business to Allegheny. As Prof. Miller describes it:
After the deal closed, Allegheny discovered that some of the key financial information Merrill provided in due diligence was false. The facts get very complicated at this point, in part because the Merrill employee running the GEM business prior to the transaction had embezzled millions of dollars from Merrill (he’s now in jail) and in part because of disputes about accounting methodologies used in preparing the information. The parties disagree about exactly which statements in the information Merrill produced in due diligence were false, why they were false, and what various of Merrill employees knew or should have known about their falsity at the time the agreement was signed.
Because of these problems, Allegheny subsequently failed to honor a put right in the agreement and make a $115 million payment to Merrill. Merrill sued to compel this payment and Allegheny counter-claimed for fraudulent inducement and breach of the representations in the agreement. The lower court dismissed Allegheny's counter-claims after a bench-trial, but the Second Circuit reversed. I refer you to Prof. Miller's cogent analysis for the reasons why -- but basically the opinion was a straightforward application of New York law on the issues of fraudulent inducement and breach.
The interesting thing is the following representation in the purchase agreement by Merrill warranting that the information provided by Merrill to Allegheny was “in the aggregate, in [Merrill’s] reasonable judgment exercised in good faith, is appropriate for [Allegheny] to evaluate [GEM’s] trading positions and trading operations.” As Prof. Miller notes this representation:
should take the breadth away from any practicing . . . . Merrill is representing that the information it provided was “appropriate” for Allegheny’s evaluating the business. At the very least, this means that Merrill is warranting that it reasonably believed that it delivered all the information that Allegheny needed to value the business. Hence, omissions from due diligence will become actionable. If Merrill had any information it did not produce to Allegheny in due diligence, Allegheny will now argue that such information was reasonably necessary for it to value the business and so its non-delivery to Allegheny was a breach.
By agreeing to this warranty Merrill was essentially placing a high burden on itself to justify any omissions from due diligence in the case of any disputes. The representation can also be reasonably interpreted as warranting the truth of Merrill's due diligence materials, an unbelievably wide-reaching representation. The provision is very unusual, and it is likely that Merrill agreed to it knowing this fact due to potential abnormal problems in the due diligence process prior to signing. Nonetheless, as Prof Miller again observes, given its scope it is unlikely Merrill was fully advised by their lawyers of the ramifications of this representation, who themselves may not have realized what they were agreeing to. Although a charitable view is that Merrill fully knew what it was doing but agreed to this bargain based on its limited liability under the indemnification provisions. Pure speculation since I have not seen the actual purchase agreement.
Ultimately, one of the things this dispute and particular representation highlight is the caution M&A lawyers must have in drafting representations. I was often shocked in private practice to find that M&A lawyers in both the big shops and otherwise often didn't have a full grasp of the scope and ramifications of representations instead preferring to over-rely on the "form". When they strayed they often agreed to overly broad or vague representations without appreciating the potential liability created. In addition, many lawyers lacked complete understanding of the relationship between these warranties and the indemnification provisions in private agreements. For example, they often failed to recognize the need to strip materiality qualifiers out when a de minimis was present, failed to generally appreciate double materiality qualifiers and their effect on closing and indemnification, and often argued vociferously that the limitations on indemnification should apply to the covenants. I think much of the reason for this is firm incentives to train associates are diminished in the billable hour world and instead the firms tend to over-rely on their form and network effects (i.e., they will learn on the job from other attorneys) to substitute for this needed training.
Prof. Miller and I have had an off-line conversation on this case. I understand he is going to write a post on it over at Truth on the Market which I will link to when it is up.
Monday, September 10, 2007
On Friday, Congress approved legislation cutting subsidies to student-loan providers, including SLM Corp., by $20.9 billion over the next five years. The Bill now goes to President Bush for signature; his spokesperson has stated that he will sign it.
The signing of this Bill will trigger a potential renegotiation of the SLM Corp. acquisition agreement with affiliates of J.C. Flowers & Co., Bank of America and JPMorgan Chase. The argument will center over whether a material adverse change has occurred giving the buyers the ability to terminate the transaction. As backdrop, the financing for this deal has also become uncertain given the current credit crisis, and the banks financing this transaction will likely lose a significant amount of money on their committed financing if the acquisition goes through at its current price. Given that this is their position in a number of large LBO deals, the banks are desperate for relief and a solution.
The starting starting point is the merger agreement and its definition of MAE:
"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: (a) changes in GAAP or changes in regulatory accounting requirements applicable to any industry in which the Company or any of its Subsidiaries operate; (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; (c) changes in global, national or regional political conditions (including the outbreak of war or acts of terrorism) or in general economic, business, regulatory, political or market conditions or in national or global financial markets; 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; (d) any proposed law, rule or regulation, or any proposed amendment to any existing law, rule or regulation, in each case affecting the Company or any of its Subsidiaries and not enacted into law prior to the Closing Date; (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; (f) public disclosure of this Agreement or the transactions contemplated hereby, including the initiation of litigation by any Person with respect to this Agreement; (g) any change in the debt ratings of the Company or any debt securities of the Company or any of its Subsidiaries in and of itself (it being agreed that this exception does not cover the underlying reason for such change, except to the extent such reason is within the scope of any other exception within this definition); (h) any actions taken (or omitted to be taken) at the written request of Parent; or (i) any action taken by the Company, or which the Company causes to be taken by any of its Subsidiaries, in each case which is required pursuant to this Agreement.
The first issue is the most important -- whether SLM has even experienced a MAC. Here, the agreement is governed by Delaware law. 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. Here we need more information as to the effect of this change. The only thing I have seen is SLM's statement that it "estimates the adverse impact of [this Bill] to 2008-2012 net income to be less than 10 percent as compared to the matters already disclosed to the Buyer." Remember this is only the adverse impact and SLM has not given a more specific number as to total impact. Thus, we may be touching into this realm here, though we do not know all of the facts and MAC disputes are notoriously fact-dependent (and therefore judge-dependent too!).
However, if the Flowers consortium can prove a MAC there is still the matter of the highlighted carve-outs above. On these, expect SLM to argue the following:
- The new legislation is not, on the whole, more adverse than described in its 10-K (exclusion (b));
- The law was proposed in some form at the time of the agreement; and
- The change is to the financial services industry generally and is not disproportionate to SLM (exclusion (e)).
1 and 3are carve-outs highlighted in the definition above which the parties agree do not constitute a MAC even if they are a materially adverse change. The interesting thing here is that both 1 and 3 are not qualified by "materiality". So, the Flowers consortium will likely argue that it need only prove that the change is materially adverse to the company and is either adverse (in the case of 1) or disproportionate (in the case of 3) in any amount to SLM. A cent of adverseness or disproportionality would arguably work here, and as noted above SLM has admitted there is an adverse impact. [Also, note the exclusion in (e) -- it specifically excludes changes excluded from clause (b) under the proviso]. Ultimately, this is again a fact-based determination, but it appears that Flowers has a long way to go here to prove a MAC though it is helped by the lack of materiality qualifiers in the carve-outs.
All of this may not matter much as the Flowers consortium also has a walk-away right under the agreement if it pays a reverse termination fee of $900 million dollars. This changes the negotiating position of the Flowers group substantially. Expect them to attempt to preserve their reputation for not walking from deals by publicly proclaim a MAC has occurred, but privately claim that the deal calculus now makes it more economical to walk. The consortium will find encouragement from their bankers who may also now find it more economical to simply pay or share the reverse termination fee with the buyers. This would be a similar renegotiation that occurred in Home Depot's sale of its supply business which ended with a cut of eighteen percent in the deal price.
Reading tea-leaves, I would expect Flowers to use the reverse termination fee and colorable MAC claims to negotiate some form of price cut. But, as with most MAC renegotiations, expect it to happen behind closed doors. Any renegotiation will require a new shareholder vote, so even if there is a renegotiation there will not be a closing in the immediate future.
Addendum: One point of clarification on the above -- when I say that SLM will argue that the law is proposed, I am not referring to the MAC carve-out on proposed laws, but that SLM will argue that Flowers already knew of the possibility of this legislation at the time of the agreement.