M & A Law Prof Blog

The Next Victim Please (Reddy Ice)

The demise of the PHH Corp. deal has me thinking about the next victim of the 2007/2008 private equity blow-out.  I think the clear nominee for the dead pool has to be Reddy Ice Holdings -- it currently has a Feb 5 termination date for its merger agreement, a date which seems increasingly likely to bring the agreement's termination. 

Back on July 2 Reddy Ice, the largest maker of packaged ice in the United States, announced that it had agreed to be acquired by GSO Capital Partners for $681.5 million in a deal valued at $1.1 billion including debt.  Debt financing for the transaction was committed by Morgan Stanley.  According to the merger agreement, the deal had a 45-day go-shop and a $7 million dollar break fee during the go-shop period, rising to $21 million thereafter.  At the time I celebrated Reddy's apropos slogan "Good Times are in The Bag", not picking up that the merger agreement also contained an ominously low $21 million reverse termination fee. 

The deal quickly shifted into troubled category. The definitive proxy statement describes a deal almost immediately in crisis after announcement as Reddy Ice was hit by shareholder protests against the price by Noonday Asset Management, L.P. and Shamrock Activist Value Fund L.P. and the company missed July earnings targets.  By mid-August GSO was already asserting that it needed more time to market the financing for the transaction given the state of the debt markets and Reddy Ice itself.  In light of these problems, GSO and Reddy Ice ultimately agreed to amend the merger agreement on August 30, 2007 to cap the future dividends Reddy Ice could pay while the transaction was pending, extend GSO's marketing period for the debt financing, move up the date of the Reddy Ice shareholder meeting to October 15, 2007, and reduce the maximum fee payable to GSO if Reddy Ice's shareholders rejected the transaction from $7 million to $3.5 million. Notably, Reddy Ice backed away from its initial position vis-a-vis GSO that it required an extension of the go-shop period and a postponement of the shareholder meeting in exchange for these amendments.  According to the proxy statement, it did so because of fears that GSO would simply walk from the transaction by paying the reverse termination fee of $21 million.  Reverse termination fees are powerful negotiating tools folks. 

Morgan Stanley then promptly raised an objection to the amendment.  We have little information on this objection but from the little public disclosure it appears that MS is claiming that the merger agreement amendment and its extension of the marketing period was entered into without MS's consent thereby disabling its obligations under the commitment letter, a fact MS stated it reserved its rights with respect thereto.  GSO and Reddy Ice publicly disputed MS's claim and the transaction is not contingent on financing (NB. unless it claims a MAC GSO has no other choice but to take this position or simply pay the reverse termination fee).  The MS debt commitment letter is not publicly available but the language is likely standard and requires the banks approval to amendments of the merger agreement that are not  "material and adverse to the interests of the Lenders" or some formulation thereof.  If this is indeed the language, one can quibble whether these amendments, particularly the extension of the marketing period, are adverse.  Nonetheless this is a similar position which the financing banks also successfully took in the Home Depot Supply renegotiation.

That was all by the end of summer, but since then Reddy Ice has continued its slow melt (pun very much intended).  The new go-shop period came and went without a bidder, on Nov. 30 its CEO Jimmy C. Weaver resigned and on Jan 2 Reddy Ice announced that its COO Raymond Booth had also resigned. Meanwhile, management (now gone) has thrice lowered full-year guidance blaming adverse weather conditions since the announcement of the agreement.  Note that the MAC contains an exclusion for adverse effects based on weather conditions -- Reddy Ice's finger-pointing at the weather not coincidentally provides it a convenient out on the MAC. The only good news for the deal is that Reddy Ice's shareholders have approved it. 

And thus far, GSO has not asserted a MAC (for the definition of a MAC see pp. 53-54 of the merger agreement).  But on Oct. 5, GSO informed Reddy Ice that it planned to extend the marketing period for the deal's $775 million debt package through Jan. 31. According to the merger agreement amendment the drop-dead date for deal is defined as follows:

“End Date” shall mean December 15, 2007, provided that the Company shall have the right, in its sole discretion to extend the End Date by up to 60 days if any of the conditions set forth in Sections 6 or 7 shall not have been satisfied or waived as of December 1, 2007, provided, further, that if the Marketing Period has commenced but not ended before any such End Date (including as a result of any extension pursuant to the final proviso of the definition of the term “Marketing Period”), such End Date shall automatically be extended to occur three Business Days after the final day of the Marketing Period.

And marketing period is defined as follows:

“Marketing Period” means the first period of 20 consecutive calendar days after all of the conditions set forth in Section 6 (other than conditions that by their nature can only be satisfied at the Closing) have been satisfied . . . . provided further that, prior to the expiration of the Marketing Period, the Parents shall be entitled in their sole discretion, from time to time on written notice to the Company, to extend the duration of the Marketing Period beyond a 20 calendar day period to end on any date on or prior to January 31, 2008 and, if, and only if, the Company consents in its sole discretion following the request of the Parents, to extend the duration of the Marketing Period beyond a 20 calendar day period to end on a date after January 31, 2008 but on or prior to February 28, 2008.”

The bottom-line is that the marketing period expires on Jan 31 unless the parties agree to extend it to Feb 28.  And if the financing is not in place by Jan 31 or the Feb 28 extension, section 8.1(i) of the merger agreement provides that it can be terminated:

(i) by the Company if the Parents have failed to consummate the Merger by 5:00 p.m. on the third Business Day after the final day of the Marketing Period and all of the conditions set forth in Section 6 would have been satisfied if the Closing were to have occurred on such date.

The third business day after Jan 31 is Feb 5.  The signs are ominous -- there has been no word from the parties on the status of the debt marketing (and no word that it has even begun).  Moreover, it does not appear that Reddy Ice has commenced the tender offer for its 10 1/2 percent discount notes as contemplated (if requested by GSO) by section 5.11 the merger agreement.  It appears that the only issue left in this deal is whether GSO quietly decides to pay the reverse termination fee of $21 million or assert a MAC to limit its payment and negotiate a lower reverse termination fee.  In such a case we may very well have another sort-of MAC dispute in Delaware -- the choice of law and forum of the merger agreement.  But I doubt Reddy Ice will pick this fight -- left without a management team and a rapidly declining business Reddy Ice will likely want to move on as other (Acxiom, Harman) have done to restore their business and their market credibility.  GSO likely knows this and will play hardball on the fee. 

Of course there is also the issue of MS's conduct.  In September I would have speculated that MS would not be treating a first-tier private equity firm like Blackstone this way.  But as the Fall has progressed and the potential liability increased it is clear that banks are willing to risk even their largest clients to wriggle away from some of these deals. 

Final lesson:  For M&A lawyers, remember that financing commitment letters as currently drafted can provide financing banks an out if the deal is renegotiated.  Consider negotiating for wider language permitting freer amendment of the transactions documents and particularly consider denoting specific amendments which can be made without bank approval (e.g., lowering of the consideration, extension of the marketing period, etc.)

Final Note: For those who enjoy their deal code names, in the merger agreement merger sub is Hockey MergerSub and its parents are Frozen, LLC and HockeyParent.  Sort of cute. 

Myers Industries: The True Option

Well -- fresh off my post yesterday about the Future of Private Equity M&A and the hope for PE deals, Myers Industries became the latest train wreck triggered by a reverse termination fee.  It appears that the reputational constraints are becoming less of a barrier to exercising these provisions as time passes and more private equity firms do so.  Myer's announcement stated: 

The Board of Directors of Myers Industries, Inc. (NYSE: MYE) today announced that GS Capital Partners (GSCP) has requested more time to complete the acquisition of the Company. In consideration for extending the closing date of the transaction from December 15, 2007 to April 30, 2008, GSCP has agreed to make a non-refundable payment to Myers of the previously agreed upon $35 million fee. GSCP has secured an extension of its debt financing commitments from Goldman Sachs Credit Partners and Key Bank pursuant to which GSCP has agreed to contribute another $30 million of equity to the transaction.

GSCP has acknowledged that there has been no material adverse change in Myers' business, and that GSCP's deadline extension request resulted from its desire to further evaluate conditions in certain industries in which Myers operates.

Isn't that nice of GSCP -- this is now the second deal (after Harman) that GSCP has backed out of -- they are on the list with Cerberus.  And it was not coincidental that the $35 million payment by GSCP referred to above was the same amount as the reverse termination fee in the merger agreement.  NB.  This provision was clearly drafted by Fried Frank, counsel for GSCP -- Myers had no choice here -- the $35 million was the best it could get. 

And this is where it gets really interesting.  In the Letter Agreement signed with respect to this payment, the parties amend the merger agreement to remove any other penalty GSCP is subject to if it fails to complete the acquisition.  Again, they do not terminate the agreement, but rather amend it.  The Letter Agreement states:

MergerCo hereby agrees to pay, or cause to be paid, to the Company an amount equal to $35 million (the "Fee") in immediately available funds on the second Business Day following the date of this Letter Agreement in satisfaction of any obligation MergerCo may have under Section 8.6(c) of the Merger Agreement. The Fee is nonrefundable. The Company hereby waives any right that it has against Parent, MergerCo or the Guarantors to recover any other fee or damages pursuant to, arising out of or in connection with the Merger Agreement (including any right to recover the MergerCo Termination Fee pursuant to Section 8.6(c) of the Merger Agreement) in the event that the transactions contemplated by the Merger Agreement are not consummated for any reason (including the termination or any alleged breach of the Merger Agreement). The Company hereby agrees that from and after the date of this Letter Agreement, it is not entitled to, and will not seek, specific performance or any equitable remedy against Parent, MergerCo, the Guarantors, or any of their respective Affiliates, arising out of, or in connection with, the consummation of the Merger or failure to consummate the Merger.

Yet, since the merger agreement is still in effect, GSCP now has a true option on Myer Industries for the already paid lump sum of $35 million. Per the letter agreement, the option is exercisable until the merger agreement is terminated by  Myers (which it can do fifteen days after the date that Myers delivers to GSCP Myers' unaudited quarterly financial statements for the period ended March 31, 2008) or by GSCP (which it can do after April 30, 2008). Mitigating this boon to GSCP, Myers is provided in the Letter Agreement full latitude to solicit and enter into discussions with third parties concerning competing bids -- the termination fee is also reduced to $0, although GSCP still has a six business day matching right.  In addition, the covenants limiting pre-closing actions by Myers are largely stripped.  The end result is to turn the merger agreement into a an option; GSCP now has a four month period to decide whether or not to exercise it and buy Myer.  A good deal for $35 million given the volatility in the market. 

URI/Cerberus: The Complaint

RAM said it would need to draw on its committed bridge financing facilities, but in the current credit markets it was not prepared to impair relationships with RAM’s financing sources by forcing them to fund [the acquisition of United Rentals]. . . .

--  URI Complaint alleging the reasons why Cerberus has repudiated its agreement with URI and perhaps revealing where Cerberus's true allegiances lie.

United Rentals yesterday filed suit against the Cerberus acquisition vehicles, RAM Holdings, Inc. and RAM Acquisition Corp. (for ease of reference I will refer to them as Cerberus).  The complaint is about as straight-forward as they get.  United Rentals sole claim is that Section 9.10 of the merger agreement requires specific performance of Cerberus's obligations.  Section 9.10 of the United Rentals/Cerberus merger agreement states:

The parties agree that irreparable damage would occur in the event that any of the provisions of this Agreement were not performed in accordance with their specific terms or were otherwise breached. Accordingly . . . . (b) the Company shall be entitled to seek an injunction or injunctions to prevent breaches of this Agreement by Parent or Merger Sub or to enforce specifically the terms and provisions of this Agreement and the Guarantee to prevent breaches of or enforce compliance with those covenants of Parent or Merger Sub that require Parent or Merger Sub to (i) use its reasonable best efforts to obtain the Financing and satisfy the conditions to closing set forth in Section 7.1 and Section 7.3, including the covenants set forth in Section 6.8 and Section 6.10 and (ii) consummate the transactions contemplated by this Agreement, if in the case of this clause (ii), the Financing (or Alternative Financing obtained in accordance with Section 6.10(b)) is available to be drawn down by Parent pursuant to the terms of the applicable agreements but is not so drawn down solely as a result of Parent or Merger Sub refusing to do so in breach of this Agreement. The provisions of this Section 9.10 shall be subject in all respects to Section 8.2(e) hereof, which Section shall govern the rights and obligations of the parties hereto (and of the Guarantor, the Parent Related Parties, and the Company Related Parties) under the circumstances provided therein.

United Rentals must still get around Section 8.2(e) of the merger agreement which purports to trump this provision and limit Cerberus's aggregate liability to no more than $100,000,000.  This clause states: 

(e) Notwithstanding anything to the contrary in this Agreement, including with respect to Sections 7.4 and 9.10, (i) the Company’s right to terminate this Agreement in compliance with the provisions of Sections 8.1(d)(i) and (ii) and its right to receive the Parent Termination Fee pursuant to Section 8.2(c) or the guarantee thereof pursuant to the Guarantee, and (ii) Parent’s right to terminate this Agreement pursuant to Section 8.1(e)(i) and (ii) and its right to receive the Company Termination Fee pursuant to Section 8.2(b) shall, in each case, be the sole and exclusive remedy, including on account of punitive damages, of (in the case of clause (i)) the Company and its subsidiaries against Parent, Merger Sub, the Guarantor or any of their respective affiliates, stockholders, general partners, limited partners, members, managers, directors, officers, employees or agents (collectively “Parent Related Parties”) and (in the case of clause (ii)) Parent and Merger Sub against the Company or its subsidiaries, affiliates, stockholders, directors, officers, employees or agents (collectively “Company Related Parties”), for any and all loss or damage suffered as a result thereof, and upon any termination specified in clause (i) or (ii) of this Section 8.2(e) and payment of the Parent Termination Fee or Company Termination Fee, as the case may be, none of Parent, Merger Sub, Guarantor or any of their respective Parent Related Parties or the Company or any of the Company Related Parties shall have any further liability or obligation of any kind or nature relating to or arising out of this Agreement or the transactions contemplated by this Agreement as a result of such termination. The parties acknowledge and agree that the Parent Termination Fee and the Company Termination Fee constitute liquidated damages and are not a penalty and shall be the sole and exclusive remedy for recovery by the Company and its subsidiaries or Parent and Merger Sub, as the case may be, in the event of the termination of this Agreement by the Company in compliance with the provisions of Section 8.1(d)(i) or (ii) or Parent pursuant to Section 8.1(e)(i) and (ii), including on account of punitive damages. In no event, whether or not this Agreement has been terminated pursuant to any provision hereof, shall Parent, Merger Sub, Guarantor or the Parent Related Parties, either individually or in the aggregate, be subject to any liability in excess of the Parent Termination Fee for any or all losses or damages relating to or arising out of this Agreement or the transactions contemplated by this Agreement, including breaches by Parent or Merger Sub of any representations, warranties, covenants or agreements contained in this Agreement, and in no event shall the Company seek equitable relief or seek to recover any money damages in excess of such amount from Parent, Merger Sub, Guarantor or any Parent Related Party or any of their respective Representatives.

United Rentals argues that this damages limitation clause does not bar its specific performance claim since:

RAM implied in its November 14, 2007 letter that this explicit contractual provision, headed “Specific Performance” has no force and effect because of language in Section 8.2(e) of the Merger Agreement. But RAM is incorrect. As reflected in the language of the Merger Agreement itself, and as described in the Proxy Statement that RAM and its counsel reviewed and signed off on, Section 8.2(e) limits rights to equitable relief only in the event that the Merger Agreement has been terminated.

I'm surprised at this argument.  The limitation in Section 8.2(e) specifically has the qualification:  "In no event, whether or not this Agreement has been terminated pursuant to any provision hereof . . . ."  This would seem to make its applicability wider than just termination events.  Moreover, Section 9.10 specifically makes its provisions subject to clause 8.2(e).  I just don't think that United Rental's argument here is compelling since a better, though not certain reading, of this clause would be that its liability cap is applicable in circumstances other than termination of the agreement. 

Instead of the above argument, I would have thought that United Rentals would have argued what I postulated they would the other day: 

Conversely, United Rentals is going to argue that "equitable relief" here refers to other types of equitable relief than set out in Section 9.10 and that to read Section 8.1(e) any other way would render Section 9.10 meaningless. United Rentals will also argue that specific performance of the financing commitment letters here is at no cost to Cerberus and so the limit is not even met. 

But United Rentals has the benefit of the lawyers who negotiated for them and the currently non-public parol evidence as to how the contract was meant to be read, so perhaps the plain fact is that clause 8.2(e), though in-artfully drafted, was actually meant to be interpreted this way.  Still, I wonder how United Rentals will ultimately explain the qualification "whether or not this agreement has been terminated".  Regardless, this is a clearly ambiguous contract; this is a conclusion I can make even before reading Cerberus's response.  This dispute will have to be resolved at trial in Delaware Chancery Court -- an event that is 6-9 months out at best, even on an expedited basis. 

Finally, United Rentals makes a big deal in their complaint about their proxy disclosure, and Cerberus's failure to correct it.  United Rentals claims that this shows that their interpretation is the correct one.  I'm not so sure about this.  While ex post facto conduct can evidence the parties intentions with respect to the contract, their reading of the proxy statement can easily be disputed by Cerberus.  Moreover, Cerberus's failure to comment here is weak evidence as opposed to affirmative, conscious conduct.   For those who want to read the proxy disclosure and make their own conclusions, here it is: 

Specific Performance

Parent, Merger Sub and the Company have agreed that irreparable damage would occur in the event that any of the provisions of the merger agreement were not performed in accordance with their specific terms or were otherwise breached. Accordingly, the parties have agreed that they shall be entitled to seek an injunction to prevent breaches of the merger agreement and to be able to enforce specifically the terms and provisions of the merger agreement, in addition to any other remedy to which such party is entitled at law or in equity, including the covenants of Parent or Merger Sub that require Parent or Merger Sub to (i) use its reasonable best efforts to obtain the financing and satisfy certain conditions to closing, and (ii) consummate the transactions contemplated by the merger agreement, if the financing (or alternative financing) is available to be drawn down by Parent pursuant to the terms of the applicable agreements but is not so drawn down solely as a result of Parent or Merger Sub refusing to do so in breach of this Agreement. The provisions relating to specific performance are subject to the rights and obligations of the parties relating to receipt of payment of the termination fee, as described above under “Fees and Expenses,” under the circumstances described therein.

Fees and Expenses

The merger agreement provides that our right to terminate the merger agreement in the above circumstances and receive payment of the $100 million termination fee is the sole and exclusive remedy available to the Company and its subsidiaries against Parent, Merger Sub, the guarantor and any of their respective affiliates, stockholders, general partners, limited partners, members, managers, directors, officers, employees or agents for any loss or damage suffered as a result of such termination.

To the extent this proxy disclosure is actually unambiguous, my guess is that United Rentals post-signing recognized the uncertainty in the actual agreement and tried to cure it here without raising Cerberus's ire or comment.  The result is the neutral language above which I believe is still far from definitive and certainly not dispositive.  I think United Rentals is grasping for parol evidence.  I suspect that this may be because there is not really anything out there on paper evidencing the negotiation of this provision other than mark-ups -- further weakening their case in light of their less than compelling argument above.

Final question:  what then were the proxy comments of Cerberus which URI alledgedly ignored and which Cerberus referred to in its August 31 letter? 

N.Y. Times on PE Buy-outs

The N.Y. Times today has an article by Sorkin: "If Buyout Firms Are So Smart, Why Are They So Wrong?".  It's about the recent spate of private equity firms reneging on their deals.  I'm quoted in it. 

Cerberus's 13D

It is now day three of the United Rentals/Cerberus saga.  Still no lawsuit by United Rentals.  I'm a bit surprised -- I would have thought that they had the complaint ready to go and would have filed yesterday to keep momentum. 

Yesterday's big development in the dispute was Cerberus's filing of a 13D amendment.  The filing included a copy of Cerberus's limited guarantee.  The guarantee had not previously been made public, Cerberus clearly included this agreement in its filing in order to publicly reinforce its argument that Cerberus is only liable for the $100 million termination fee and not a dollar more.  The guarantee specifically limits Cerberus's liability to $100 million and contains a no recourse clause.  This clause provides in part: 

The Company hereby covenants and agrees that it shall not institute, and shall cause its controlled affiliates not to institute, any proceeding or bring any other claim arising under, or in connection with, the Merger Agreement or the transactions contemplated thereby, against the Guarantor [Cerberus] or any Guarantor/Parent Affiliates except for claims against the Guarantor under this Limited Guarantee.

NB. the definition of Guarantor/Parent Affiliates above specifically excludes the Merger Sub. 

I have no doubt that Cerberus is going to argue that this limited guarantee, when read with the merger agreement, reinforces its interpretation of the agreement that specific performance is NOT available.  Again, unfortunately, there is vagueness here.  The integration clause of the limited guarantee states: 

Entire Agreement. This Limited Guarantee constitutes the entire agreement with respect to the subject matter hereof and supersedes any and all prior discussions, negotiations, proposals, undertakings, understandings and agreements, whether written or oral, among Parent, Merger Sub and the Guarantor or any of their affiliates on the one hand, and the Company or any of its affiliates on the other hand, except for the Merger Agreement.

So, this means that when interpreting the limited guarantee a judge will also look to the merger agreement for context and guidance.  I put forth my analysis of the merger agreement yesterday (read it here).  Nonetheless, it would appear that this limited guarantee creates more uncertainty, though to the extent it is given any reading it reinforces Cerberus's position, with one possible exception.

This exception is Merger Sub -- the acquisition vehicle created by Cerberus to complete the transaction.  Essentially, this guarantee says nothing about what merger sub can and cannot do.  So, a possible United Rentals argument is that merger sub can be ordered by the court to specifically enforce the financing letters against Cerberus and the Banks.  To the extent that the merger agreement permits specific performance (a big if) this would side-step the guarantee issue. 

Ultimately, though, the vagueness means that a Delaware judge will need to look at the parol evidence -- that is the evidence outside the contract -- to find what the parties intended here.  What this will reveal we don't know right now -- so I must emphasize strongly that, while I tend to favor United Rental's position, it is impossible to make any definitive conclusions on who has the better legal argument at this point. 

Note:  The Limited Guarantee has a New York choice of law clause and has an exclusive jurisdiction clause siting any dispute over tis terms in New York County.  The merger agreement has a Delaware choice of law and selects Delaware as the exclusive forum for any dispute.  This mismatch is sloppy lawyering -- it is akin to what happened in Genesco/Finish Line.  And while I have not seen the financing letters for the United Rentals deal, my hunch is that the bank financing letters have similar N.Y. choice of forum and law provisions.  This very much complicates the case for United Rentals and Cerberus as any lawsuit in Delaware will inevitably end up with Cerberus attempting to implead the banks or United Rentals suing the banks outright (if they can under the letters).  If the financing letters have a different jurisdictional and law choice it makes things that much more complicated.  M&A lawyers should be acutely aware of this issue for future deals. 

Final Note:  Weekend reading for everyone is the United Rentals proxy (access it here).  Let's really find out what they did and did not disclose about the terms of this agreement and the deal generally. 

The Dog Bites: A True Story

Background

This Fall has been remarkable for private equity M&A stories, but yesterday perhaps the most remarkable one unfolded.  It began early in the day when United Rentals, Inc. announced that Cerberus Capital Management, L.P. had informed it that Cerberus was not prepared to proceed with the purchase of United Rentals.  United Rentals stated:

The Company noted that Cerberus has specifically confirmed that there has not been a material adverse change at United Rentals. United Rentals views this repudiation by Cerberus as unwarranted and incompatible with the covenants of the merger agreement. Having fulfilled all the closing conditions under the merger agreement, United Rentals is prepared to complete the transaction promptly.

The Company also pointed out that Cerberus has received binding commitment letters from its banks to provide financing for the transaction through required bridge facilities. The Company currently believes that Cerberus’ banks stand ready to fulfill their contractual obligations.

United Rentals also announced that it had retained boutique litigation firm Orans, Elsen & Lupert LLP to represent it in this matter on potential litigation.  Simpson Thacher represented United Rentals in the transaction but is likely conflicted out from representing United Rentals in any litigation due to the involvement of banks represented by Simpson in financing the transaction and the banks' likely involvement in any litigation arising from this matter (more on their liability later).  United Rentals later that day filed a Form 8-K attaching three letters traded between the parties on this matter.  Cerberus's last letter sent today really says it all and is worth setting out in full: 

Dear Mr. Schwed:

We are writing in connection with the above-captioned Agreement. As you know, as part of the negotiations of the Agreement and the ancillary documentation, the parties agreed that our maximum liability in the event that we elected not to consummate the transaction would be payment of the Parent Termination Fee (as defined in the Agreement) in the amount of $100 million. This aspect of the transaction is memorialized in, among other places, Section 8.2(e) of the Agreement, the final sentence of which reads as follows:

“In no event, whether or not this Agreement has been terminated pursuant to any provision hereof, shall Parent, Merger Sub, Guarantor or the Parent Related Entities, either individually or in the aggregate, be subject to any liability in excess of the Parent Termination Fee [$100 Million] for any or all losses or damages relating to or arising out of this Agreement or the transactions contemplated by this Agreement, including breaches by Parent or Merger Sub of any representations, warranties, covenants or agreements contained in this Agreement, and in no event shall the Company seek equitable relief or seek to recover any money damages in excess of such amount from Parent, Merger Sub, Guarantor or any Parent Related Party or any of their respective Representatives.”

In light of the foregoing, and after giving the matter careful consideration, this is to advise that Parent and Merger Sub are not prepared to proceed with the acquisition of URI on the terms contemplated by the Agreement.

Given this position and the rights and obligations of the parties under the Agreement and the ancillary documentation, we see two paths forward. If URI is interested in exploring a transaction between our companies on revised terms, we would be happy to engage in a constructive dialogue with you and representatives of your choosing at your earliest convenience. We could be available to meet in person or telephonically with URI and its representatives for this purpose immediately. In order to pursue this path, we would need to reach resolution on revised terms within a matter of days. If, however, you are not interested in pursuing such discussions, we are prepared to make arrangements, subject to appropriate documentation, for the payment of the $100 million Parent Termination Fee. We look forward to your response.

We should all save this one for our files.   

Cerberus's Gumption

Back in August when I first warned in my post, Private Equity's Option to Buy, on the dangers of reverse termination fees, I speculated that it would be a long Fall as private equity firms decided whether or not to walk on deals that were no longer as economically viable and which had reverse termination fees.  I further theorized that one of the biggest barriers to the exercise of these provisions was the reputational issue.  Private equity firms would be reluctant to break their commitments due to the adverse impact on their reputational capital and future deal stream.  This proved true throughout the Fall as time and again in Acxiom, Harman, SLM, etc. private equity firms claimed material adverse change events to exit deals refusing to simply invoke the reverse termination fee structure and be seen as repudiating their agreements.  I believe this was due to the reputational issue (not to mention the need to avoid paying these fees). 

Cerberus is completely different.  Nowhere is Cerberus claiming a material adverse change.  Cerberus is straight out stating they are exercising their option to pay the reverse termination fee, breaking their contractual commitment and repudiating their agreement.  Cerberus has decided that the reputational impact of their actions is overcome in this instance by the economics.  And this is now the second deal, after Affiliated Computer Services, that Cerberus has walked on in the past month.  The dog not only bites, it bites hard.  Any target dealing with them in the future would now be irresponsible to agree to a reverse termination provision.  Nonetheless, Cerberus is smart money; clearly, they think walking from this deal outweighs any adverse impact on their ability to agree to and complete future transactions. 

It Gets Complicated 

It is actually not that simple, though.  United Rental's lawyers did not negotiate a straight reverse termination fee.  Instead, and unlike in Harman for example, there is a specific performance clause in the merger agreement. Section 9.10 of the United Rentals/Cerberus merger agreement states:

The parties agree that irreparable damage would occur in the event that any of the provisions of this Agreement were not performed in accordance with their specific terms or were otherwise breached. Accordingly . . . . (b) the Company shall be entitled to seek an injunction or injunctions to prevent breaches of this Agreement by Parent or Merger Sub or to enforce specifically the terms and provisions of this Agreement and the Guarantee to prevent breaches of or enforce compliance with those covenants of Parent or Merger Sub that require Parent or Merger Sub to (i) use its reasonable best efforts to obtain the Financing and satisfy the conditions to closing set forth in Section 7.1 and Section 7.3, including the covenants set forth in Section 6.8 and Section 6.10 and (ii) consummate the transactions contemplated by this Agreement, if in the case of this clause (ii), the Financing (or Alternative Financing obtained in accordance with Section 6.10(b)) is available to be drawn down by Parent pursuant to the terms of the applicable agreements but is not so drawn down solely as a result of Parent or Merger Sub refusing to do so in breach of this Agreement. The provisions of this Section 9.10 shall be subject in all respects to Section 8.2(e) hereof, which Section shall govern the rights and obligations of the parties hereto (and of the Guarantor, the Parent Related Parties, and the Company Related Parties) under the circumstances provided therein.

If this provision were viewed in isolation, then I would predict that United Rentals will shortly sue in Delaware to force Cerberus to specifically perform and enforce its financing letters.  Cerberus would then defend itself by claiming that financing is not available to be drawn under the commitment letters and implead the financing banks (akin to what is going on with Genesco/Finish Line/UBS).  In short, Cerberus would use the banks as cover to walk from the agreement.  And based solely upon this provision, United Rentals would have a very good case for specific performance, provided that the banks were still required to finance the deal under their commitment letters.  Something United Rentals claims they are indeed required to do. 

But there is a big catch here.  Remember Cerberus's letter up above?  It is worth repeating now that the last sentence of Section 8.1(e) of the merger agreement states:

In no event, whether or not this Agreement has been terminated pursuant to any provision hereof, shall Parent, Merger Sub, Guarantor or the Parent Related Parties, either individually or in the aggregate, be subject to any liability in excess of the Parent Termination Fee for any or all losses or damages relating to or arising out of this Agreement or the transactions contemplated by this Agreement, including breaches by Parent or Merger Sub of any representations, warranties, covenants or agreements contained in this Agreement, and in no event shall the Company seek equitable relief or seek to recover any money damages in excess of such amount from Parent, Merger Sub, Guarantor or any Parent Related Party or any of their respective Representatives.

Note the underlined/bold language:  under Section 8.1(e) equitable relief is specifically subject to the $100,000,000 cap.  As every first year law student knows, specific performance is a type of equitable relief.  Furthermore, Section 9.10 is specifically made subject to 8.1(e) which in fact begins with the clause "Notwithstanding anything to the contrary in this Agreement, including with respect to Sections 7.4 and 9.10 . . . ."

Thus, Cerberus is almost certainly going to argue that Section 8.1(e) qualifies Section 9.10 and that specific performance of the merger agreement can only be limited to $100,000,000.  Conversely, United Rentals is going to argue that "equitable relief" here refers to other types of equitable relief than set out in Section 9.10 and that to read Section 8.1(e) any other way would render Section 9.10 meaningless. United Rentals will also argue that specific performance of the financing commitment letters here is at no cost to Cerberus and so the limit is not even met. 

So, who has the better argument?  First, the contract is vague enough that the Delaware Chancery Court will likely have to look at parol evidence -- evidence outside the contract to make a determination.  What this evidence will show is unknown.  Nonetheless, I think United Rentals still has the better argument.  Why negotiate Section 9.10 unless it was otherwise required to make Cerberus enforce its financing commitment letters?  To read the contract Cerberus's way is to render the clause meaningless.  This goes against basic rules of contract interpretation. And the qualification at the beginning of Section 8.1(e) "Notwithstanding anything to the contrary in this Agreement, including with respect to Sections 7.4 and 9.10 . . . ." can be argued to only qualify the first sentence not the last sentence referred to above.  Ultimately, Gary Horowitz at Simpson who represented United Rentals is a smart guy -- I can't believe he would have negotiated with an understanding any other way. 

The Bottom-Line

The bottom-line is that this is almost certainly going to litigation in Delaware.  Because of the specter and claims that United Rental will make for specific performance, Cerberus will almost certainly then implead the financing banks.  And as I wrote above, it appears that right now, based on public information, United Rentals has the better though not certain argument.  Of course, even if they can gain specific performance, the terms of the bank financing may still allow Cerberus to walk.  That is, the financing letters may provide the banks an out -- an out they almost certainly will claim they can exercise here.  I don't have the copies of the letters and so can't make any assessment of their ability to walk as of now, though United Rentals is claiming in their press release above that the banks are still required under their letters to finance this transaction. 

Ultimately, Cerberus is positioning for a renegotiation.  But unlike SLM and Harman, Cerberus has the real specter of having to do more than pay a reverse termination fee:  they may actually be required to complete the transaction.  Like the Accredited Home Lenders/Lone Star MAC litigation, this is likely to push them more forcefully to negotiate a price at which they will acquire the company.  United Rentals is also likely to negotiate in order to eliminate the uncertainty and move on with a transaction.  But, they are in a much stronger position than SLM which only has the reverse termination fee as leverage.  M&A lawyers representing targets should note the difference to their clients before they agree to only a reverse termination fee.  In United Rental's case, though, it still likely means a settlement as with most MAC cases.  The uncertainties I outline above likely make a trial too risky for United Rental's directors to contemplate provided Cerberus offers an adequate amount of consideration. 

Coda on Possible Securities Fraud Claims

According to one of Cerberus's letters filed today, Cerberus requested on August 29 to renegotiate the transaction. They also expressed concerns in that letter that their comments on United Rentals merger proxy weren’t taken.  United Rentals responded that they were politely considered and disregarded.  It's a good bet that the comments disregarded were Cerberus requesting United Rentals to disclose in the proxy statement that United Rentals cannot get specific performance and United Rentals ignoring them.  To say the least it was a bit risky for Untied Rentals to mail a proxy statement that does not disclose in the history of the transaction that the other side is trying to renegotiate the deal, and has specifically disagreed with your disclosure as to specific performance rights.  Here come the plaintiff's lawyers. 

How to Draft a Reverse Termination Fee Provision

There have now been four relatively large private equity transactions announced since the August credit/market crisis:  3Com ($2.2 billion), Radiation Therapy Services $(1.1 billion), Goodman Global ($2.65 billion), and Puget Energy ($7.4 billion).  Given this growing, yet still small, dataset, I thought it would be a good time to assess how private equity reverse termination fees are being drafted and whether there has been any shift in market practice post-August.  So, let's start with the Goodman Global merger agreement which was filed last Thursday and negotiated by attorneys at O'Melveny for Goodman Global and Simpson Thacher for the private equity buyer, Hellman & Friedman.

Section 7.1(e) permits termination:

(e) by the Company by notice to Parent, if (i) Parent shall have breached or failed to perform in any material respect any of its representations, warranties, covenants or other agreements contained in this Agreement, which breach or failure to perform . . . . or (ii) the conditions to closing set forth in Section 6.1 and Section 6.3 (other than the condition set forth in Section 6.3(c)) are satisfied on the final day of the Marketing Period and Parent and Merger Sub have not received the proceeds of the Debt Financing or Equity Financing (other than as a result of failure by the Company to satisfy the condition set forth in Section 6.3(c)) on or prior to the final day of the Marketing Period;

Note the underlined terms in the second prong of the termination right.  This provides Goodman Global with a termination right if H&F refuses to close the transaction due to a failure of the debt OR equity financing for any reason whatsoever. 

The merger agreement then sets forth in Section 7.2(c) a manner for Goodman Global to receive a $75 million termination fee in such circumstances:

In the event that this Agreement is terminated by the Company pursuant to Section 7.1(e)(ii) and the notice of termination includes a demand, which demand shall be irrevocable, to receive the Parent Termination Fee (a “Parent Termination Fee Notice”), Parent shall pay $75,000,000 (the “Parent Termination Fee”) to the Company no later than two (2) Business Days after such termination. . . .

NB.  Under Section 7.2(d) Goodman Global is also entitled in these circumstances to a repayment of fees and expenses up to $5 million.

But this does not end the matter.  Section 7.2(e) states: 

Anything in this Agreement to the contrary notwithstanding, (i) the maximum aggregate liability of Parent and Merger Sub for all Company Damages shall be limited to $139,200,000 (the “Parent Liability Limitation") . . . .

Section 7.2(e) caps the aggregate liability of H&F to $139,200,000 for any breach of the merger agreement; elsewhere in Section 8.5(a) of the agreement it provides that specific performance is not available to Goodman Global under any circumstances.  So, H&F can absolutely walk from the transaction knowing that its maximum liability under any circumstance is $139,200,000.

So, this begs the question -- what is the reverse termination fee here $75 million or $139 million (3% or 5% of the deal value)?  By the terms of the agreement it is $75 million if all of the conditions are satisfied and only the financing is unavailable.  In such a situation, Goodman Global can terminate and collect the $75 million.  In all other circumstances, Goodman will have to sue for failure of H&F to complete and can receive damages up to the $139 million.  The agreement specifically excepts out specific performance of the bank/hedge fund commitment letters and nowhere does it permit a suit based on the banks' failure to adhere to their commitment letters.  Presumably, although the agreement can be read ambiguously on this point, if the financing is unavailable and Goodman Global can otherwise prove that the conditions to the agreement are not satisfied, it can choose not to terminate the agreement and instead try and collect up to the maximum $139 million. But if Goodman Global decides to choose door number 1 and the $75 million it cannot pursue a greater amount of damages. 

This is important.  Because of the mechanics and incentives of the parties here, I doubt you will ever have a situation where the private equity firm is unwilling to close in circumstances where the financing is available.  Or to again rephrase, if the private equity firm does not want to close, it can collaborate with the financing banks/hedge funds to claim that the financing is unavailable for reasons under the agreement (read, material adverse change, etc.).  In such a case, Goodman Global is faced with a choice, terminate and claim that the conditions are satisfied and receive the $75 million.  Or sue, and attempt to collect up to the $139 million.  Otherwise, the agreement has incentives to push H&F towards payment of the $75 million.  For, if H&F's failure to pay the termination fee:

is not the subject of a bona fide dispute, the Company shall be entitled to seek and receive, in addition to the Parent Termination Fee and/or the expense reimbursement pursuant to Section 7.2(d), interest thereon and the Company’s costs and expenses of collection thereof (including reasonable attorneys’ fees and expenses).

Though theoretically the $139 million is available, the above structure creates bargaining incentives which will push Goodman Global to take the $75 million termination option in almost all circumstances.  It will want to get past a bad deal, terminate as soon as possible, settle around the $75 million and move onward.  The alternative is to be seen as the litigating party, slug through such litigation over the existence of a material adverse effect or some other alleged failure of a condition and try and get a damages claim up to the $139 million.  The extra $50 million is not worth it.  Conversely, the buyer will be able to claim they settled for the lesser amount against an uncertain case.   

And for those who want support that this is what will happen, Acxiom had just such a structure in its agreement and surprise, that was what occurred there (see more here). 

Both 3Com and Radiation Therapy also have similar structures (see the merger agreements here and here, respectively).  Puget Sound has not filed its merger agreement but is not a useful reference due to the long period between signing and closing for a utility deal.  And I think Goodman Global is the best drafted of the three for those looking for precedent. 

I'm very surprised that this is the model that is developing.  I suppose the higher payment permits the seller to trumpet a higher possible reverse termination fee while not having to agree to a financing condition (note that all of the press releases for these deals did not have the formerly usual statement of "There is no financing condition").  Though, again, the parties will naturally gravitate to the lower threshold.  And given the still jumpy credit markets any reverse termination fee creates a higher risk of no completion.  So, for lawyers adopting this model I think they would do well to advise their clients of the incentives in this structure and simplify it.  The Goodman Global model can be built upon to provide a greater certainty of a higher reverse termination fee for the seller -- here the interplay of the two clauses means that the higher cap is likely to be only illusory.  But the additional drafting creates ambiguity.  Lawyers who negotiate this model may do well to simplify it with only one slightly higher fee compromising perhaps at 4%.

Of course,  I still prefer the Avaya model which requires specific performance on the debt and equity commitment letters as a compromise.  Avaya, by the way, closed last week.

Final Thought:  Only Puget of the four has a go-shop provision.  This is an interesting development.  Perhaps parties are realizing the issues with these mechanisms and more carefully considering their use.   On this note, Christina Sautter has a forthcoming article, Shopping During Extended Store Hours: From No Shops to Go-Shops - the Development, Effectiveness, and Implications of Go-Shop Provisions in Change of Control Transactions.  It is an intelligent, thorough look at go-shops and the first of what is likely to be a wave of academic articles on the subject. 

On Hiatus Today/Goodman Global

I'll be back on Monday.  For weekend reading, here is the Goodman Global merger agreement with Hellman & Friedman via Chill Acquisition Corp.  Some fun things in it which I will talk about next week, including the following atypical condition to H&F's completion of the merger:

The Company and its Subsidiaries, on a consolidated basis, shall have realized not less than $255 million in EBITDA (as hereinafter defined) for the fiscal year ended December 31, 2007. “EBITDA” shall mean EBITDA as defined in the existing indenture, dated as of December 23, 2004, governing the 7 7/8% Senior Subordinated Notes due 2012 of Holdings modified as follows: (i) business optimization expenses and other restructuring charges under clause (4) thereof shall only be permitted to be added back up to an aggregate amount of $5,000,000 for the twelve -month period ended December 31, 2007 and (2) EBITDA for the 3-month period ended March 31, 2007 and June 30, 2007, respectively, shall be deemed to be $32,700,000 and $88,300,000, respectively.

Funny, they didn't put that in their Monday press release.   

The Return of Private Equity

Two mid-sized private equity transactions have been announced in the last few days.  On Friday, Radiation Therapy Services, Inc. announced that the company had agreed to be purchased by Vestar Capital for $32.50 per share plus assumed debt, for a deal valued at $1.1 billion.  Then today, Goodman Global, Inc. announced that it has agreed to be acquired by Hellman & Friedman LLC in an all-cash transaction valued at approximately $2.65 billion or $25.60 in cash per share.  The credit markets must indeed be loosening if private equity deals are once again being announced, even if it is only deals for a billion or so. 

Reviewing both press releases one is struck by the absence of any statement concerning the existence or lack thereof of a financing condition.  In the case of RTS the reason why became apparent today when RTS filed its merger agreement.  There is actually no financing condition but true to form the deal has a cap on the buyer's liability of $40 million.  However, per Section 7.2(b), the termination fee is $25 million plus payment of RTS's fees and expenses up to $3 million if the agreement is terminated by RTS if the buyer has breached the agreement or otherwise refused to close upon satisfaction of the conditions.  Anyway, the agreement isn't drafted or structured well on these points, but I couldn't find any conflux of events that would result in RTS receiving more than the $25 million.  This is because if RTS terminates the agreement then the buyer is only liable for the $25 million still leaving the question open as to what circumstances would lead to the $40 million cap.  I suppose just going to court and leaving the agreement open -- but this is an unpalatable situation for any seller as Harman has recently seen to its detriment.   

And this explains why there is no financing condition statement in the RTS press release.  The parties probably realize that the reverse termination fee is effectively a financing condition.  Win one for truth in advertising.   Other terms of the RTS agreement are a $25 million termination fee and a seller obligation to pay the buyer's fees up to $3 million if the deal is voted down.  There is also a no-shop (whither the go-shop so soon?). 

I'll have more on these two deals once the Goodman Global merger agreement is filed. 

Harman: Bad Reception

After a four week wait, Harman International today finally announced the termination of its merger agreement with Kohlberg Kravis Roberts & Co. L.P. (“KKR”) and GS Capital Partners.  According to the press release, the agreement includes the following (surprising) terms:

KKR and GSCP will purchase $400 million of 1.25% senior notes convertible under certain circumstances into Harman common stock, convertible at a price of $104 per share. KKR and GSCP have agreed to not sell or hedge their position for at least one year.

The parties have agreed to terminate their Merger Agreement dated April 26, 2007 without litigation or payment of a termination fee.

In addition, in connection with the investment Harman also announced that Brian F. Carroll, a member of KKR, will join Harman’s Board of Directors, and that Harman will use the proceeds from the KKR/GSCP investment to repurchase Harman common stock through an accelerated share repurchase program.

How bizarre.  I've blogged before about the weak case KKR and GSCP appeared to have based on the public information.  They have now managed to turn a $225 liability for the termination fee on this deal into an investment that they can keep on their books for years.  Win one for the smart general partners at these funds (Flowers et al. take note).  The loser here is Harman who could have been $225 million or so richer and also received such an investment in the market from less tainted purchasers.  Of course, Harman will say that they settled this dispute in order to move on and avoid the pain of litigation, disclosure of company books and secrets and attorneys fees.  Still, this is what happens in any litigation, and I am not sure how it would have detrimentally effected their business to hold KKR and GSCP to their agreement.  Their claims are particularly suspect given their strange and disquieting conduct for the past month.    

Nonetheless, the lessons for subsequent buyers are clear -- reverse termination fees provide substantial leverage to walk from a deal -- and the subsequent rush by the seller to clean itself up can result in lowering the termination fee even further in the give and take among bargaining positions and the seller's attempts to quickly reposition itself as a "good" company. 

Some other points on this announcement also bother me.  First, there is a negotiated option on the bond to convert it to equity.  I don't have the terms yet to work out a price for this option, but I suspect that given the volatility in Harman stock it masks a sizable interest rate being paid on this bond [On the flip side of this the bond could also be priced to hide the termination fee -- that is KKR and GS could be paying the fee through the bond price].  Moreover, the board seat also strikes me as odd.  Here is an investor that was willing to walk away from a deal and leave the company and now they receive a board seat?  This is all legal but not the best corporate governance practice as it is bound to create conflict in the future -- the KKR board member has duties to Harman now -- hopefully he will fulfill them ably and in compliance with the law.  And for these reasons alone, I would have thought KKR would avoid such a board seat.  The plaintiffs' lawyers already have Harman on their radar -- they will again be quick to strike if this board member acts in violation of his duty of loyalty to Harman.   

Final note.  For those who craft press releases for a living, I include the quote of Sidney Harman issued today as a lesson in what not to say in a press release.  He stated: 

We are pleased to have reached an understanding with KKR and GSCP. Although we do not agree with the reasons for cancellation of the original merger agreement, we view this $400 million investment as a vote of confidence in our business and its prospects for continued growth.

Not surprisingly, Harman has yet to file the agreement related to this investment and the disposition of this potential claim.  I'll have more on this once the agreement is filed which will likely be the full two business days allowed under Form 8-K.

Topps Closes

Topps issued the following press release on Friday:

The Topps Company, Inc. (Nasdaq: TOPP) today announced the closing of the acquisition of Topps by Michael Eisner's The Tornante Company LLC and Madison Dearborn Partners, LLC. Under the terms of the agreement, Topps stockholders will receive $9.75 in cash for each share of Topps common stock held, for a total aggregate purchase price of approximately $385 million payable to stockholders.

"This is a great day for Topps and its shareholders," said Arthur T. Shorin, Chief Executive Officer of Topps. "This transaction provides our former investors with full value for their shares and ensures the further success of our iconic company."

Topps President and Chief Operating Officer Scott Silverstein added, "We are pleased to have an experienced and talented group of investors who are committed to growing our company and to delivering added value to our partners, the people who enjoy our products every day, and our terrific team of employees whose efforts have made this transaction possible."

"Topps is a wonderful company with a rich history and a strong brand portfolio. We look forward to working with the company's outstanding management and employees to grow Topps in new and innovative ways," Eisner said on behalf of the investors.

Given the way the Topps board manipulated the takeover process and spurned a higher offer from Upper Deck, both over vociferous shareholder objections, I'm not sure how great a day it was for Topps' shareholders.  They have now lost out on the potential upside Eisner et al. have purchased.  Eisner wins again for now. 

There was also no mention in the above release of the final number of dissenting shareholders, but it must have been below the 15% condition set in the merger agreement.  Still, Crescendo Partners has delivered to Topps a written demand for the appraisal of 2,684,700 shares of Topps common stock (or approximately 6.9% of the total number of outstanding shares of Topps common stock).  In a nice maneuver, they will not get to negotiate for a higher price outside the takeover process. 

Despite the loss of Topps as a public company we will still have a Delaware decision (In re Topps Shareholders Litigation, 2007 WL 1732586 (Del.Ch. June 14, 2007)) and a great case study in how not to run a takeover process.  Sayanora Topps.  For my prior posts on the Topps deal see the following:

Topps: The End Game of Dissenters' Rights

Topps and In re: Appraisal of Transkaryotic...

Topps: Not Over Yet

Topps Shareholder Meeting Tomorrow

Topps's Predictable Postponement

Topps's Car Wreck

Upper Deck Extends Tender Offer

Topps's Dilemma

Upper Deck Ducks a Second Request

Topps Postpones Shareholder Meeting

Upper Deck Tries to Buy Time

Topps and Upper Deck: The Antitrust Risk

More on Topps

In Re Topps Company Shareholders Litigation/In...

The Battle for Topps

Trading Baseball Card Companies

Och-Ziff and Black Market Capital

It is being reported that Och-Ziff, the hedge fund adviser, set a price range of $30 to $33 a share for its proposed initial public offering of 36 million shares.  When it occurs, this will be the third hedge fund or private equity fund adviser ipo after Blackstone and Fortress and marks a return of these ipos post-August market crisis.  KKR is the next one on-deck, but expect more of them.  I outline the reasons why in my recent paper Black Market Capital:

In my paper, I note that retail investors cannot invest in hedge funds or private equity funds but they can invest in the funds' managers. I argue that the trend of hedge fund and private equity fund adviser initial public offerings is in part due to the SEC rules which prohibit public investment in these funds. Prevented from buying the funds directly, public investors look for something replicating their benefits. The investment banks and other financial actors act quickly meet this demand, but with less suitable and riskier investment vehicles such as fund adviser IPOs, special purpose acquisition companies, business development companies, structured trust acquisition companies, and specialized exchange traded funds all of which largely attempt to mimic private equity or hedge fund returns and have been marketed to public investors on this basis.  I term these investments “black market” capital since they are a product of the ban on direct hedge fund and private equity public investing.  I argue that these investment tend to be more risky on an individual basis than the hedge fund and private equity funds they substitute for.  So, public investors who buy them bear more risk and together inject more risk into the US capital markets than if they were allowed to invest in the funds.  These are a perverse consequence of the SEC’s current prohibition.  I argue that the SEC should resolve these issues by amending the securities laws to permit public investors to invest directly in private equity and hedge funds. This would recognize the costs in the current regime, end black market capital and allow investors to access the benefits of hedge funds and private equity: excess returns and diversification.

You can download Black Market Capital here. 

3Com -- Surprise. Surprise.

Yesterday, 3Com filed its merger agreement.  As I read it, I felt like one of those cult members who predicts the end of the Earth on a date certain and wakes the day after to find everything still there.  Do they repent?  No, they fit the new facts into their situation and keep their belief. 

Well, 3Com did not go the Avaya route as I predicted.  Instead, they kept to the old private equity structure and included a highly negotiated reverse termination fee structure.  Essentially, 3Com and their lawyers (Wilson Sonsini) agreed that the buyers (Bain and Huawei) have a pure walk right if they pay a termination fee of $110,000,000 (Section 8(j) of the merger agreement).  This is about 5% of the transaction value of $2.2 billion.  And in certain situations, such as if the debt financing falls through, the buyers would only be liable for $66,000,000 if they breach the merger agreement and walk (I spell out these situations at the end of this post).

So, how do we explain this?  Well, one of the other interesting things about the 3Com merger agreement is that it is not conditioned upon financing; a fact 3Com did not even publicize in its press release or make an explicit condition in the merger agreement.  So, I think the conversation went something like this:  3Com -- we can't agree to this reverse termination fee as it will give you too much optionality.  Bain -- OK, well we can't expose our investors to liability for the full purchase price; if you won't agree to this then we need a financing condition.  Plus, we are really nice people and would never do that to you.  Banks piling on -- we won't finance this deal if there is specific performance on our commitment letters.  3Com -- OK -- no financing condition -- but we want a high termination fee of 5% to compensate us if you do indeed walk without a reason.  So, like the cult survivor this is my best explanation in order to keep my belief in rational negotiating, although there is a lower termination fee if the financing falls through, so I am still struggling to see the logic of the terms here.  In their conference call on Friday, 3Com was particularly unhelpful in talking about the terms of the agreement -- refusing to answer questions on the amount of the Huawei investment and instead stating "you’re going to have to wait a couple days or a little while before you can get specific answers to those questions."  They were also a bit defensive about the fact that one analyst suggested that if you exclude 3Com's ownership of H3C it values the remainder of 3Com at "$0.75, $0.80" a share.  Ouch. 

I'm also a bit troubled by some of the other terms which 3Com and its lawyers negotiated.  First, there is no go-shop in the transaction.  Even though these provisions have their problems (see my post on this here), it does provide some opportunity for other bidders to emerge and shields the seller from claims of favoritism, so I am a bit surprised 3Com did not include it.  In addition, if 3Com shareholders vote down the transaction, 3Com agreed in clause 8.3(b)(v) to reimburse the buyers for their fees and expenses up to $20 million.  This is unusual and an excessive amount of money for 3Com to pay merely because its shareholders exercised their statutory voting rights to reject the deal.  The termination fee in case of a competing bid is a market standard of $66 million (3% of the deal value) and does not require that the company pay the fees and expenses of the buyers. 

I think the most annoying part of the agreement from my perspective was this clause 7.1(b) which conditioned the merger occurring on:

(b) Requisite Regulatory Approvals. (i) Any waiting period (and extensions thereof) applicable to the transactions contemplated by this Agreement under the HSR Act shall have expired or been terminated, (ii) any waiting periods (and extensions thereof) applicable to the transactions contemplated by this Agreement under the Antitrust Laws set forth in Schedule 7.1(b) shall have expired or been terminated, and (iii) the clearances, consents, approvals, orders and authorizations of Governmental Authorities set forth in Schedule 7.1(b) shall have been obtained.

Read the highlighted condition.  Of course, 3Com did not disclose Schedule 7.1(b) and refused to answer questions on the agreement on their conference call yesterday.  So, investors at this point still don't know all of the conditions to the deal.  I can't see how this is not a material omission in violation of the federal securities laws (read my post on the SEC action against Titan).   I really wish the SEC would crack down on this practice since a shareholder action on this claim is a loser because of the holding in Dura Pharmaceuticals (see my post on this here).  It is particularly important here because the inclusion of a Chinese buyer might lead to an Exon-Florio filing for this deal.  And the condition that we can't see might be exactly that -- a condition that Exon-Florio clearance is required to complete the deal.  Given that this is a Chinese buyer it is bound to attract CFIUS scrutiny whether justified or not.  In this case, it may be justified -- apparently sharing 3Com's networking technology with the Chinese does raise national security concerns.  (By the way, for an explanation of the Exon-Florio process and the term CFIUS see my first post today here).  Shame on 3Com for not disclosing the condition immediately or even informing the public of the amount of the Chinese investment at this time.  If 3Com is indeed going to clear Exon-Florio in this transaction they need to handle their public relations better.

Finally the MAC clause is in the definitions and states: 

“Company Material Adverse Effect” shall mean any effect, circumstance, change, event or development (each an “Effect”, and collectively, “Effects”), individually or in the aggregate, and taken together with all other Effects, that is (or are) materially adverse to the business, operations, condition (financial or otherwise) or results of operations of the Company and its Subsidiaries, taken as a whole; provided, however, that no Effect (by itself or when aggregated or taken together with any and all other Effects) resulting from or arising out of any of the following shall be deemed to be or constitute a “Company Material Adverse Effect,” and no Effect (by itself or when aggregated or taken together with any and all other such Effects) resulting from or arising out of any of the following shall be taken into account when determining whether a “Company Material Adverse Effect” has occurred or may, would or could occur: (i) general economic conditions in the United States, China or any other country (or changes therein), general conditions in the financial markets in the United States, China or any other country (or changes therein) or general political conditions in the United States, China or any other country (or changes therein), in any such case to the extent that such changes, effects, events or circumstances do not affect the Company and its Subsidiaries in a disproportionate manner relative to other participants in the industries in which the Company and its Subsidiaries conduct business; (ii) general conditions in the industries in which the Company and its Subsidiaries conduct business (or changes therein) to the extent that such changes, effects, events or circumstances do not affect the Company and its Subsidiaries in a disproportionate manner relative to other participants in the industries in which the Company and its Subsidiaries conduct business; (iii) any conditions arising out of acts of terrorism, war or armed hostilities to the extent that such conditions do not affect the Company and its Subsidiaries in a disproportionate manner relative to other participants in the industries in which the Company and its Subsidiaries conduct business; (iv) the announcement of this Agreement or the pendency or consummation of the transactions contemplated hereby, including the impact thereof on relationships (contractual or otherwise) with suppliers, distributors, partners, customers or employees; (v) any action taken by the Company or its Subsidiaries that is required by this Agreement, or the failure by the Company or its Subsidiaries to take any action that is prohibited by this Agreement; (vi) any action that is taken, or any failure to take action, by the Company or its Subsidiaries in either case to which Newco has approved, consented to or requested in writing; (vii) any changes in Law or GAAP (or the interpretation thereof); (viii) changes in the Company’s stock price or change in the trading volume of the Company’s stock, in and of itself (it being understood that the underlying cause of, and the facts, circumstances or occurrences giving rise or contributing to such circumstance may be deemed to constitute a “Company Material Adverse Effect” (unless otherwise excluded) and shall not be excluded from and may be deemed to constitute or be taken into account in determining whether there has been, is, or would be a Company Material Adverse Effect; (ix) any failure by the Company to meet any internal or public projections, forecasts or estimates of revenues or earnings in and of itself (for the avoidance of doubt, the exception in this clause (ix) shall not prevent or otherwise affect a determination that the underlying cause of such failure is a Company Material Adverse Effect); or (x) any legal proceedings made or brought by any of the current or former stockholders of the Company (on their own behalf or on behalf of the Company) resulting from, relating to or arising out of this Agreement or any of the transactions contemplated hereby.

For those of you who have better things to do than slog through this definition, it is favorable to 3COM -- it contains no forward-looking element and specifically excludes failure to meet projections from the definition among other things. 

Final Conclusion:  3Com is an unusual deal for a variety of reasons.  In addition, the model in 3Com is one that Wilson Sonsini has negotiated in other deals (see, e.g., Acxiom). It may indeed signal that past practices here with respect to private equity deals and reverse termination fees will continue as the norm albeit with higher buyer reverse termination fees.  But, like the cult survivor, for now I'm going to keep my belief and hope that its singularity will not effect future practice and that the Avaya model will become the standard.   Or at least that firms other than Wilson Sonsini might learn quicker and go that route. 

Addendum:  Reverse Termination Fee.

The relevant termination clause here is clause 8.1(g) which permits termination:

   (g) by the Company, in the event that (i) all of the conditions to the obligations of Newco and Merger Sub to consummate the Merger set forth in Section 7.1 and Section 7.2 have been satisfied or waived (to the extent permitted hereunder), (ii) the Debt Financing contemplated by the Debt Commitment Letters, Senior Secured Credit Agreement and/or Bridge Agreement (or any replacement, amended, modified or alternative Debt Commitment Letters, Senior Secured Credit Agreement and/or Bridge Agreement permitted by Section 6.4(b)) has funded or would be funded pursuant to the terms and conditions set forth in such Debt Commitment Letters, Senior Secured Credit Agreement and/or Bridge Agreement upon funding of the Equity Financing contemplated by the Equity Commitment Letters; (iii) Newco and Merger Sub shall have breached their obligation to cause the Merger to be consummated pursuant to Section 2.2 and (iv) a U.S. Federal regulatory agency (that is not an antitrust regulatory agency) has not informed Newco, Merger Sub or the Company that it is considering taking action to prevent the Merger unless the parties or any of their Affiliates agree to satisfy specified conditions (which may but need not include divestiture of a material portion of the Company’s business) other than as contemplated by Section 5.5 of the Company Disclosure Schedule, or such regulatory agency has informed the parties that it is no longer considering such action; or

If the agreement is terminated under this clause then the buyers are required to pay the Newco Default Fee ($110 million).  The clause limiting the buyers to paying this amount is in 8.3(g) (Limitation of Remedies) and  9.7 (Specific Performance).  Of particular importance, note that the debt financing must be funded for this termination provision to be triggered.  If the debt financing or other conditions above are not met, the buyers are then liable for the lesser amount of $66 million for breaching the agreement (clause 8.3(c)(i)).   

Black Market Capital Quoted Extensively in the Financial Times Today

David Wighton, the New York Bureau Chief for the Financial Times, quotes extensively from my new article Black Market Capital in his lead-in article to today's Report on Fund Management in the Financial Times.  The article is entitled SEC seeming perverse about risk and is accessible on the FT website here.  You can also get it on the newstand.  A few quotes for flavor:

"Told you so," said many critics of hedge funds surveying the damage caused by the summer credit market turmoil. The high-profile collapse of several funds and the dismal performance of many others have provided just the ammunition the sceptics were looking for. Surely it proved that hedge funds were dangerous and should be kept out of the hands of retail investors, they said. How wise of the Securities and Exchange Commission to propose barring individuals with less than $2.5m (£1.2m, €1.8m) in liquid assets from investing in hedge funds, up from the current limit of $1m.

This is nonsense. Average hedge fund returns are generally less volatile than the equity market as a whole and you are much more likely to lose your shirt on an individual stock than on a hedge fund. The rules preventing small investors from putting money into hedge funds are positively perverse.

As Steven Davidoff, a professor at Wayne State University Law School, points out in a new paper, the rules have an even more perverse consequence.

Retail investors may not be able to invest in hedge funds - or private equity funds for that matter - but they can invest in the funds' managers, which Prof Davidoff argues are more risky.

"This is because the future income of an adviser is derivative upon the fund advisers' capacity to continually earn extraordinary positive returns." If they do not earn such returns, investors will shift money away, which means the impact on the investor in the manager will be greater than on the investor in the fund.

Prof Davidoff suggests that the spate of flotations of alternative asset managers - albeit slowed by the credit market turmoil - is partly the result of the rules against public issues by alternative funds. Prevented from buying the funds directly, public investors look for something that replicates their benefits. The financial industry quickly meets that demand. But it does so with less suitable vehicles such as asset managers, special purpose acquisitions companies and the growing array of exchange-traded funds and indexes that attempt to track private equity or hedge fund performance.

These vehicles, which Prof Davidoff dubs Black Market* Investments, tend to be more risky on an individual basis than the hedge fund and private equity funds they substitute for. So public investors who buy them bear more risk and together inject more risk into the US capital markets than if they were allowed to invest in the funds.

Investors' other option is to buy funds on non-US markets, a process that the SEC is considering making easier. But without the benefit of SEC regulatory oversight and the US securities law enforcement, Prof Davidoff argues that this would be more risky and costly than a prohibited US-based purchase of the funds.

Investors should be allowed to make up their own minds on whether hedge funds are good value for money. The asset qualification for retail investors should not be raised. It should be scrapped.

Check it out. 

Avaya and 3Com: Why are these PE Deals Different From All Other PE Deals?

On Friday, 3Com Corporation announced that it had agreed to be acquired by affiliates of Bain Capital Partners, LLC, for approximately $2.2 billion in cash. This is the first big private equity deal announced post-August market crisis.  As such, I'm excited for 3Com to file the merger agreement this week; it will give us a good window on how transaction participants and M&A attorneys have reacted to revise previously standard structures in light of market developments.  My big bet -- expect there to be no reverse termination fee -- that is, a clause which gives the private equity buyer an absolute right to walk from the deal by paying a pre-set fee, typically 3-5% of the deal value (for more on these see my post here).  Instead, expect the parties in 3Com to adopt the structure used in the Avaya transaction where Avaya agreed to be acquired by Silver Lake and TPG Capital for approximately $8.2 billion or $17.50 per common share.

The Avaya merger agreement was one of the only private equity transactions pre-market crisis to specifically provide for the opposite of a reverse termination fee -- specific performance.  In Section 7.3(f) of the merger agreement the parties specifically cap monetary damages in case of breach but provide for specific performance.  This effectively ends the optionality contained in the other private equity agreements with reverse termination fees.   Here is the relevant language:

Notwithstanding the foregoing, it is explicitly agreed that the Company shall be entitled to seek specific performance of Parent’s obligation to cause the Equity Financing to be funded to fund the Merger in the event that (i) all conditions in Sections 6.1 and 6.2  have been satisfied (or, with respect to certificates to be delivered at the Closing, are capable of being satisfied upon the Closing) at the time when the Closing would have occurred but for the failure of the Equity Financing to be funded, (ii) the financing provided for by the Debt Commitment Letters (or, if alternative financing is being used in accordance with Section 5.5, pursuant to the commitments with respect thereto) has been funded or will be funded at the Closing if the Equity Financing is funded at the Closing, and (iii) the Company has irrevocably confirmed that if specific performance is granted and the Equity Financing and Debt Financing are funded, then the Closing pursuant to Article II will occur.  For the avoidance of doubt, (1) under no circumstances will the Company be entitled to monetary damages in excess of the amount of the Parent Termination Fee and (2) while the Company may pursue both a grant of specific performance of the type provided by the preceding sentence and the payment of the Parent Termination Fee under Section 7.1(b), under no circumstances shall the Company be permitted or entitled to receive both a grant of specific performance of the type contemplated by the preceding sentence and any money damages, including all or any portion of the Parent Termination Fee.

Practitioners take note for future deals.

Additional Point:  Given the difference between the Avaya deal and the other private equity deals, I was surprised to see the wild fluctuation in the Avaya stock price last week.  This is a much more certain deal than the SLM Corp. and other private equity deals with reverse termination fees.  Unless the buyers here can establish a MAC (which doesn't appear to be the case based on public information) this deal will close so long as the financing letters remain in place.  I don't believe Avaya has disclosed these commitment letters, but presumably these are as tight as the merger agreement and can only be terminated for a similar MAC and other customarily significant reasons.  Also, presumably if Avaya's lawyers negotiated a specific performance clause in the merger agreement they also demanded one in the commitment letters, so that they could ensure that the debt financing needed for the buyers to specifically perform under the clause above would be available.  But perhaps the market is actually efficient here and is seeing something I do not. 

Incidentally, Avaya stockholders approved the transaction on Friday -- the deal now goes into the debt marketing stage, and under the merger agreement is required to close by the end of the marketing period.  The marketing period ends 20 business days from this past Friday provided Avaya has provided all the relevant information it is required to under the merger agreement to the buyers.