Saturday, August 22, 2020

Okay, So They’re Not Quite Raffles v. Wichelhaus

This week, I want to call attention to two recent Delaware decisions involving disputes over the meaning of contractual language in merger agreements, because I find the purity of the interpretive questions posed to be aesthetically pleasing. 

First up, we have Schneider National Carriers v. Kuntz, where the court denied cross motions for summary judgment on the grounds that the contract was ambiguous.  Schneider acquired all of the stock of W&S in exchange for upfront cash payments and earnouts pegged to meeting certain annually-increasing EBITDA targets over the following three years.  As is common in earnout arrangements, Schneider agreed to certain operating covenants, the most critical of which was a covenant that Schneider would, during each Measurement Period, “cause one or more of the Acquired Companies to acquire, in the aggregate, not less than sixty (60) class 8 tractors.”

The question for the court was whether this language meant that Schneider should actually grow the total number of tractors by 60, or could those 60 include replacements for tractors that were retired?  If the latter, Schneider was in compliance; if the former, not so much, because Schneider retired more tractors than it acquired.  In the end – as one would expect if assets were shrinking – the acquired companies did not meet their EBITDA targets, leading to the lawsuit.

At this point I have to pause to admire the beauty of the problem.  It is sheer elegance in its simplicity.

The court had earlier determined the language to be ambiguous in cross-motions for judgment on the pleadings, so now, at the summary judgment stage, it looked to extrinsic evidence.  And what was this evidence?  Well, there was a lot of testimony regarding oral negotiations – and unsurprisingly, each side offered differing accounts – so the real action was in the documents.  And that showed that the EBITDA targets themselves were based on projections that assumed tractor growth.  And growth was actually written into Schneider’s early drafts of the stock purchase agreement, but somewhere along the way, Schneider deleted reference to growth while maintaining reference to acquiring 60 tractors, and the sellers never called Schneider on it.

The court’s takeaway from all of this was that factual questions remained, and I suppose that’s not unreasonable, but … come on.  If you’re a seller looking for an earnout, and all of your negotiations are focused on the post-merger conduct of the business, are you going to agree to a provision that theoretically gives the buyer complete freedom to discard all the tractors in the fleet – which consisted of several hundred tractors at the time of the acquisition – so long as 60 new ones are purchased?  Probably not.  I mean, even if you assume that Schneider could only retire tractors based on some concept of “good faith” or business continuity, why would anyone specify that precisely 60 tractors had to be added if they anticipated the possibility of a relatively unconstrained offsetting decrease?  Sixty additions are meaningless if you have no idea how many are being eliminated.

A more cynical interpretation would be that the buyer deleted critical language as drafts were exchanged and hoped—correctly—that sellers would not notice the significance until it was too late.  But, we’ll see what happens as the case goes forward.

Moving on, we have RoundPoint Mortgage Servicing Corp. v. Freedom Mortgage Corp.  RoundPoint was in the business of originating, refinancing, and servicing residential mortgage loans, and almost all of its stock was held by RPFG.  Freedom agreed to acquire RoundPoint at a valuation of 7.5% above RoundPoint’s book value just before closing, minus $4,150,000.  In practical effect, then, and excluding the $4 million deduction, every dollar by which RoundPoint’s book value increased meant an increase in payments to RPFG of that amount, plus 7.5%.

RoundPoint was concerned that it might have to pay certain margin calls before closing, and – because the merger agreement did not permit it to sell assets – would have insufficient liquidity to do so.  As a result, Freedom agreed in Section 7.02 of the Merger Agreement to allow RPFG to lend RoundPoint the necessary funds, but closing required that RoundPoint “shall have repaid, all amounts outstanding under the RPFG Facility.”

The problem was that after RPFG advanced those funds to RoundPoint, it simply forgave most of the debt.  By doing so, RPFG functionally added what appears to have been over a hundred million dollars to RoundPoint’s book value, which, of course, meant Freedom was obligated to pay RPFG 7.5% over that amount.

Freedom argued that unless RoundPoint repaid the full amounts loaned – regardless of any formal debt forgiveness – Freedom was relieved of its closing obligations.  Was it?

Here, we have a delightful dispute over emphasis: is the critical phrase “shall have repaid,” so that if RoundPoint did not actually repay the amounts loaned, the condition is not satisfied?  Or is the critical phrase “all amounts outstanding,” so that the condition is satisfied so long as there is no outstanding debt to RPFG?

A trial was held solely on Section 7.02, with additional proceedings regarding the rest of the Agreement to be held later.  And, based solely on that Section, without reference to other provisions, the court held for RoundPoint.  In the court’s view, “If the intent was to ensure that debt be repaid and not forgiven, that intent is expressed poorly … [B]ecause Section 7.02(f), as most naturally read, does not impose a restriction on debt forgiveness, and because the Merger Agreement shows that where the parties sought to impose such restrictions they knew how to do so, I find that the parties did not intend Section 7.02(f) to prohibit forgiveness of debt under the RPFG Facility.”  The court allowed that – after examination of the remainder of the merger agreement – it might come out differently.

Now, again, color me skeptical.  At first, the contract capped the total amount of RPFG’s loan at $40 million, but as RoundPoint’s assets deteriorated and the margin calls increased, Freedom repeatedly authorized RPFG to raise the limit.  Yet under RoundPoint’s reading, RPFG had the unfettered option to require total repayment, or none, or anywhere in between, always with the knowledge that Freedom would pay 7.5% on top of every dollar of debt forgiveness. Which means that as a practical matter, to accept RoundPoint’s argument, you have to believe that the more the company's value declined, the more that Freedom agreed to pay.  If that’s the correct interpretation, I don’t see why you’d even bother calling these loans to RoundPoint at all; they’re more like exceptionally seller-friendly purchase price adjustments.

And the court understood all of that, but nevertheless found RoundPoint’s reading more “intuitive.”*

In any event, I go through this exercise because I am charmed by the classroom-ready pristineness of the dispute in each case.  I’m also amused by the tolerance of Delaware courts for contract interpretations that would hand limitless discretion to one party to decide how much to screw over the other.  But, well, that’s contracts for you; I’ll just go back to my corporate law corner where we talk about equity and fairness and duty.


*There is a smidge more to it; apparently, in the course of litigation, RPFG offered to forego the 7.5% premiums on the forgiven debt, but Freedom still sought to avoid closing. And presumably that’s because even without the premiums in the mix, Freedom would still be stuck paying a book value increased by RPFG’s capital infusions for a business that had significantly declined.  The court figured that viewed through a good-faith-and-fair-dealing lens, it wasn’t clear whether the missing covenant would have required full repayment by RoundPoint, or whether it would have required something more along RPFG’s foregone-premiums compromise. And without that clarity, there was no term the court could imply into the deal.

Ann Lipton | Permalink


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