M & A Law Prof Blog

Appraisal - Arbs and top-up options

Last week following the decision in In re Cogent, I moved on.  I mean, why not, right?  The court passed on the deal and it can now proceed to close.  Well, not everybody is like me.  Who is like a dog with a bone?  Appraisal arbs, that's who.  Take a look at this press release from Koyote Trading to Cogent shareholders. (The Deal Prof noticed this, too.)  In it they write the following: 

“We are pleased that 3M acquired a 52% stake in Cogent last week principally through the acquisition of a 38.8% stake owned by the CEO Mr. Ming Hsieh. However, as we and other owners of Cogent have been saying for some time, the $10.50 valuation is clearly inadequate by any number of metrics,” stated Zachary Prensky, co-manager of the Special Situations desk at Koyote. As stated by 3M in a press release dated Friday, October 8^th, 2010, less than 15% of the outstanding publically-owned common stock of Cogent was tendered to 3M. ...

We applaud 3M’s long term commitment to a business that we are excited about. But the price offered is inadequate to 48% of Cogent shareholders that declined to participate in 3M’s tender. With the senior management and Board of Cogent committed to the $10.50 valuation, we have no choice but to explore the possible formation of a committee of shareholders to negotiate directly with 3M for a fair and adequate price for our stake. If 3M works with us, we believe we can find a middle ground that rewards minority shareholders for their long-term support of Cogent’s business plan,” added Mr. Prensky.

So, do they really think that the Cogent board will sit down and negotiate a higher price when a court has already given its blessing to the merger agreement?  I doubt it.   No, what they are probably up it is organizing a committee to pursue appraisal.  Meet the appraisal arbs.  A memo from Latham & Watkins issued way back in 2007 outlines the strategy. 

[T]he Delaware Chancery Court issued its opinion in the Transkaryotic appraisal proceedings. The issue was whether some 10 million Transkaryotic shares acquired afterthe record date largely by hedge funds and arbitragers were entitled to appraisal even though the beneficial owners could not demonstrate that the particular shares had, in fact, either been voted against the merger transaction or had not voted at all—a statutory prerequisite for assertingappraisal rights.

The effect is to create a post-deal announcement market for target shares.  Arbs who believe that there might be some real value in an appraisal proceeding can bid the price up and pursue and action - the reasonable costs of which may be borne by the surviving company.   Looks like Koyote is thinking of something along these lines with respect to Cogent.  Of course, the thing about an appraisal proceeding - it's a battle of experts and in the end the court determines the fair value of the shares - excluding any value created by the announced transaction.  That's a little like when a student comes back to me asking for their exam to be re-graded.  If you're lucky, it might go up.  Then again, it could go down.

On a related matter, there is an open issue with top-up options and appraisal that will receive more attention as deal-makers continue their push toward ever lower and lower triggers for the top-up option.  That issue has to do with the dilutive effect of the top-up on shares that may seek appraisal.  If Cede tells us anything, it's that a court will analyze the top-up as an integrated part of the entire transaction.  That could be troublesome if a diluted appraisal arb challenges a top-up option as part of an appraisal action.

This issue was a live one in Cogent.  The plaintiffs made the following argument: 

The last argument Plaintiffs make regarding the Top-Up Option is that the appraisal rights of Cogent stockholders will be adversely affected by the potential issuance of 139 million additional shares.  They claim that the value of current stockholder’s shares may be significantly reduced as a result of the dilutive effect of a substantial increase in shares outstanding and the “questionable value” of the promissory note.  Plaintiffs argue that the Top-Up Option will result in the issuance of numerous shares at less than their fair value. As a result, when the Company’s assets are valued in a subsequent appraisal proceeding following the execution of the Top-Up Option, the resulting valuation will be less than it would have been before the Option’s exercise.

It looks like deal lawyers saw this coming, so the Cogent merger agreement included a protective provision as part of the top-up:

Plaintiffs admit that Defendants have attempted to mitigate any potential devaluation that might occur by agreeing, in § 2.2(c) of the Merger Agreement, that “the fair value of the Appraisal Shares shall be determined in accordance with DGCL § 262 without regard to the Top-Up Option, the Top-Up Option Shares or any promissory note delivered by the Merger Sub.”  Plaintiffs question, however, the ability of this provision to protect the stockholders because, they argue, a private contract cannot alter the statutory fair value or limit what the Court of Chancery can consider in an appraisal.(66) Because DGCL § 262’s fair value standard requires that appraisal be based on all relevant factors, Plaintiffs contend the Merger Agreement cannot preclude a court from taking into account the total number of outstanding shares, including those distributed upon the exercise of the Top-Up Option.  In addition, they argue that even if the parties contractually could provide such protection to the stockholders, § 2.2 of the Merger Agreement fails to accomplish that purpose because the Merger Agreement does not designate stockholders as third-party beneficiaries with enforceable rights.

 While the issue of whether DGCL § 262 allows merger parties to define the conditions under which appraisal will take place has not been decided conclusively, there are indications from the Court of Chancery that it is permissible.(67) The analysis in the cited decisions indicates there is a strong argument in favor of the parties’ ability to stipulate to certain conditions under which an appraisal will be conducted—certainly to the extent that it would benefit dissenting stockholders and not be inconsistent with the purpose of the statute. In this case, I find that § 2.2(c) of the Merger Agreement, which states that “the fair value of theAppraisal Shares shall be determined in accordance with Section 262 without regard to the Top-Up Option . . . or any promissory note,” is sufficient to overcome Plaintiffs’ professed concerns about protecting the Company’s stockholders from the potential dilutive effects of the Top-Up Option.  Accordingly, I find that Plaintiffs have not shown that they are likely to succeed on the merits of their claims based on the Top-Up Option.

When the top-up option was simply a cleaning up device to help tidy up a tender, I suspect that few merger agreements included protective provisions as part of the top-up.  If we are moving toward lower and lower top-up triggers, then this kind of protective provision will become required, lest a challenge get some traction in the courts.

-bjmq

More On Reverse Termination Fees and Merger Agreement Remedies

I’ve mentioned reverse termination fees previously on this blog.  For those of you who attended the ABA Business Law Section’s meetings in April, you’ll know that the Practical Law Company has put together an analysis of RTFs and other remedies "available to target companies in public merger agreements for a buyer's failure to close the transaction because of a willful breach or a financing failure."  The PLC study is a sophisticated analysis of RTFs and specific performance remedies in public deals announced between Q1 2009 and Q1 2010.  I highly recommend taking a look. The study can be found here. 

- AA

Will Other Suitors Come Knocking at Palm’s Door?

There has been a lot of fun merger activity and news lately.  Unfortunately for me, I’ve been bogged down in end of the semester exam angst.  But there is a deal that has caught my attention (in my prior life, I was a Silicon Valley lawyer): HP’s proposed $1.2 billion acquisition of Palm.  HP is certainly no stranger to large tech deals, and it’s no secret that Palm has been trying to find a suitor. There is some speculation about whether now that HP has stepped up other suitors will emerge given Palm’s valuable patent portfolio which some value at approximately $1.4 billion.  Of course, the usual crowds have already started investigating whether the Palm board breached its fiduciary duty to its shareholders in agreeing to sell the company to HP.  According to one plaintiff’s side firm “the deal is suspicious because it appears from a review of the Company's financial statements that the inherent value of the Company's stock is greater than $5.70 per share, because the share price was as high as $6.29 just this month prior to the announcement of the deal, because the share price has been as high as $13.58 just this year and also because it appears that the Company's Board of Directors failed to shop the Company to other potential buyers to assure that its shareholders would receive the best price possible for their shares.”  For those of you familiar with Delaware case law on this type of acquisition, you know well that Palm’s sale to HP is a change of control transaction that implicates Revlon duties.  But, this will likely be a tough case to win on fiduciary duty grounds as the Delaware courts have stated that "there are no legally prescribed steps that directors must follow to satisfy their Revlon duties."  As we have noted many times on this blog, the Delaware Supreme Court’s recent decision in Lyondell Chemical Company v. Ryan seems to confirm that only an utter failure to attempt to secure maximum value will cause directors to run afoul of their obligations under Revlon.  Moreover, the terms of the Palm-HP acquisition agreement give a lot of room for a higher bidder to emerge.  The $33 million termination fee is fairly low (approximately 2.75% of the deal value) and Palm’s board has a typical fiduciary out.  So will other suitors come knocking at Palm’s door?

-AA

K&E on Purchase Price Adjustments

As we've noted before, purchase agreements relating to the acquisition of a private target often contain one or more post-closing purchase price adjustments  (for example a working capital adjustment). As this K&E M&A update notes

While the appeal of  purchase price adjustments is indisputable, they are often subject to postclosing disputes. One of the drivers of these disputes is inattention to the details of drafting the adjustment provisions, often exacerbated by the fact that these clauses straddle the realm controlled by the legal practitioners and that managed by the financial and accounting experts.

The update offers a plethora of tips on drafting these provisions properly.

MAW

Speed-dating and the Return of Irrational Deals?

It’s been a good April for deal junkies.  There are predictions of a pickup in deal-making (although some question whether these predictions are just that).  If the last few months spate of both friendly and hostile deals are a good indication, then predictions that “The next two quarters will probably be defined as a very aggressive period of speed-dating, where companies will try out different combinations to see if they make strategic sense and are actionable,” (by Paul G. Parker, head of global mergers and acquisitions for Barclays Capital) may likely come to fruition.  Obviously there are a lot of pluses to more deals being done (especially for those of us who study deals and deal-making).  As I asked in my post earlier this week, one of the big questions will be whether deal technology like reverse termination fees (RTFs) will persist in 2010 and if so in what form.  This was hot topic at the M&A panel held this week at the Tulane University’s Corporate Law Institute. I for one hope and expect to see the continuing complexity of RTFs where buyers and sellers actually take into account deal risk, such as financing risk, rather than a return to the problematic option-style RTF structure of the private equity deals of 2004-2007.  But then again, you never know…
Chancellor Strine joked at Tulane that “We need to get past point at which boards prudently take into account risk. We need to get them to do irrational deals” since "Those are the deals that make this conference fun.”
I guess you could say that those are the deals that make my job fun as well ;-)

- AA

What is going on with reverse termination fees?

We at the M&A Law Prof blog are somewhat enamored of reverse termination fees (RTFs).  I have a draft paper (Transforming the Allocation of Deal Risk Through Reverse Termination Fees) coming out this fall in the Vanderbilt Law Review and Brian has a paper (Optionality in Merger Agreements) coming out in the Delaware Journal of Corporate Law.  Brian’s paper examines whether reverse termination fees are “a symmetrical response to the seller’s judicially-mandated fiduciary put and whether such fees represent an efficient transactional term.”  Brian’s paper is terrific, so I encourage you to read it (and no, he isn’t paying me to tell you this). For those interested in learning more about the history of the use of RTFs, take a look at Elizabeth Nowicki's nifty empirical account of "reverse termination fee clauses in acquisition agreements for deals announced from 1997 through 2007, using a data set of 2,024 observations."

My paper is an account of the use of RTFs in strategic transactions.  The abstract gives a summary:

ABSTRACT: Buyers and sellers in strategic acquisition transactions are fundamentally shifting the way they allocate deal risk through their use of reverse termination fees (RTFs). Once relatively obscure in strategic transactions, RTFs have emerged as one of the most significant provisions in agreements that govern multi-million and multi-billion dollar deals. Despite their recent surge in acquisition agreements, RTFs have yet to be examined in any systematic way. This Article presents the first empirical study of RTFs in strategic transactions, demonstrating that these provisions are on the rise. More significantly, this study reveals the changing and increasingly complex nature of RTF provisions and how parties are using them to transform the allocation of deal risk. By exploring the evolution of the use of RTF provisions, this study explicates differing models for structuring deal risk and yields greater insights into how parties use complex contractual provisions not only to shift the allocation of risk, but also to engage in contractual innovation.

My study only spans deals announced before mid-2009, so I am thinking about a part 2 of this paper that looks at the use of RTF structures in deals after mid-2009.  My question is whether, and if so how and why, RTF provisions have changed now that they have become a somewhat more mature provision in acquisition agreements and in light of predictions that happy days may be here again for dealmakers.  If you have any comments on this paper, they are especially welcome before the end of April but even after that I may be able to make some minor tweaks, so please send me your thoughts.

- AA

K&E on "Just Say No"

According to this client memo from K&E, recent takeover battles are bringing into question the continued vitality of the “just say no” defense, which allows the board of a target company to refuse to negotiate (and waive structural defenses) to frustrate advances from unwanted suitors.

According to the authors, "just say no" is more properly viewed as a tactic rather than an end, and when viewed this way,

it is apparent that the vitality of the “just say no” defense is not and will not be the subject of a simple “yes or no” answer from the Delaware courts. Instead, the specific facts and circumstances of each case will likely determine the extent to which (and for how long) a court will countenance a target’s board continuing refusal to negotiate with, or waive structural defenses for the benefit of, a hostile suitor.

MAW

 

More on NACCO Industries from Davis Polk

Brian recently posted about the NACCO Industries case (here), As he reminds us:

NACCO reminds us that if you are going to terminate a merger agreement, you better comply with all its provisions.  If you don't, if you perhaps willfully delay your notice to the buyer about a competing proposal, you might not be able to terminate without breaching.  And, if you breach, your damages will be contract damages and not limited by the termination fee provision.  Remember, you only get the benefit of the termination fee if you terminate in accordance with the terms of the agreement.  Willfully breaching by not providing "prompt notice" potentially leaves a seller exposed for expectancy damages.

Davis Polk has just issued this client alert, drawing a few more lessons from the case.  Here's a sample:

A recent Delaware Chancery Court decision raises the stakes for faulty compliance with Section 13(d) filings, holding that a jilted merger partner in a deal-jump situation may proceed with a common law fraud claim for damages against the topping bidder based on its misleading Schedule 13D disclosures.  NACCO Industries, Inc. v. Applica Inc., No. 2541-VCL (Del. Ch. Dec 22, 2009).  The decision, which holds that NACCO Industries may proceed with numerous claims arising out of its failed 2006 merger with Applica Incorporated, also serves as a cautionary reminder to both buyers and sellers that failure to comply with a "no-shop" provision in a merger agreement not only exposes the target to damages for breach of contract, but in certain circumstances can also open the topping bidder to claims of tortious interference.

MAW

Just Say No – to Earnouts

Here’s another reason to just say no to earnouts –Sonoran Scanners v PerkinElmer.  Plaintiff Sonoran argued that notwithstanding the lack “reasonable efforts” language in the asset purchase agreement that there should be an implied obligation to exert reasonable efforts in an earnout provision.  A federal appellate court in Massachusetts agreed with that argument in a recent appeal from summary judgment when it held that under Massachusetts law, there is such an implied obligation in an earnout  provision.

In the transaction, PerkinElmer purchased substantially all the assets of privately-held Sonoran Scanner for $3.5 million plus an earnout of up to $3.5 million.  Given Sonoran’s already weakened financial state, a significant portion of the initial $3.5 million was paid to Sonoran’s creditors and not to its shareholders.  Shareholders were to be paid on the back end. Under the terms of the earn-out provisions, PerkinElmer would pay Sonoran $750,000 if at least three of Sonoran Scanner’s CTP machines were sold in the first year following closing, $1.5 million (less any previously paid earn-out amounts) if at least ten machines were sold by the end of the second year, and additional earnout amounts if certain gross margin targets on sales of CTP machines were met.  The additional earnout payment (over and above the $1.5 million) during the five year payout period was a maximum of $2 million. 

The relevant earnout provision reads in part as follows:

 1.6 Earnout Adjustment

(a) The Base Purchase Price shall be subject to increase in the form of one or more payments, payable to the Seller subject to Section 7.2, as follows:

(i) If, on or before the first anniversary of the Closing Date, the Buyer has completed not less than a total of three Qualifying Product Sales (as defined below), the Buyer shall pay to the Seller, within ten business days of the first anniversary of the Closing Date, the sum of $750,000 (the "First Earnout Payment").  ...

(ii) If, on or before the second anniversary of the Closing Date, the Buyer has completed not less than a total of 10 Qualifying Product Sales (including any Qualifying Product Sales pursuant to Section 1.6(a)(i) above), the Buyer shall pay to the Seller, within ten business days of the second anniversary of the Closing Date, the sum of $1,500,000 minus the earnout amount, if any, paid to the Seller pursuant to Section 1.6(a)(i) above (the "Second Earnout Payment" ...

The way this provision is drafted, it's devoid of any language of obligation, relying solely on a conditional "if".  It's a poorly drafted earnout provision - one that almost begs to be litigated.  So, this case should be no surprise to anyone involved in the transaction. 

Notwithstanding the lack of obligatory language or specificity in the earnout provision, the appellate court, relying on MA precedent, read its conditional language to include an implied obligation of reasonable efforts.  The Massachusetts Supreme Judicial Court in Eno Sys, Inc. v Eno, (1942) held that it is implied that one who obtains the exclusive right to manufacture a product under a patent has “an implied obligation . . . to exert reasonable efforts to promote sales of the process and to establish, if reasonably possible, an extensive use of the invention.  The First Circuit reads that case to extend an implied obligation to exert reasonable efforts to an earnout provision where consideration to be paid is tied to a sales process.  

In this case, the fact that the asset purchase agreement makes some portion of the consideration contingent on back-end sales implies that the buyer will be required to exert reasonable efforts to make sales notwithstanding a lack of language in the agreement to the contrary.  For its part, PerkinElmer says it invested $2.5 million in a losing business over two years and then decided to exit the segment altogether.  PerkinElmer argued that even if it did have an implied obligation to expend reasonable efforts, it certainly did so. Whether it did or not, it's not really all that relevant this stage anymore.  It will be up to a trial court to decide whether PerkinElmer exert reasonable efforts before deciding to stop marketing the product after signing.

I'm pretty confident in assuming that the parties decided to go with an earnout as a way to "split the difference" during negotiations and come to a reasonably quick agreement rather than spend more time on valuation questions.  Consequently, they have this rather loose language that on its face does not seem to generate obligations on the side of the buyer but may leave the seller understanding something different.  In the end, the earnout becomes a deferred dispute provision.  Better just to spend the time up front on the valuation and avoid the earnout altogether.    

-bjmq

  

Just in time for the holidays

The M&A Market Trends Subcommittee of the ABA just announced that the 2009 Private Target Deal Points Study is now available to Subcommittee members here.   Highlights of the 2009 Study were presented last month at an ABA telecast on "M&A Negotiation Trends: Insights from the 2009 Deal Points Study on Private Targets." The MP3 is available here. 

If you want full access to this and the many other valuable studies published by the subcommittee, you must be (or know really well)  an active member. You can directly sign up for update alerts here. 

One supplement already in the pipeline focuses on financial sellers (i.e., VCs and private equity groups). Benchmarking "financial seller deals" with the Study sample generally, the subcommittee is trying to answer the age-old question: "Do financial sellers really get a better deal?" It expects to release this supplement at the Subcommittee's meeting in Denver (April 23-24)

MAW 

Post- Closing Purchase Price Adjustments

Agreements to purchase private companies often include a post-closing purchase price adjustment (generally based on closing working capital versus some agreed upon target). In an effort to ascertain current market practice, White & Case surveyed 87 private company purchase agreements that were publicly filed in 2008 and contained purchase price adjustments.  Full report here.

MAW

Top-Up Option Math

Just going over some older posts, and I ran across The Deal Professor’s excellent post on top up options.  I think it’s worth adding that if you’re going to counsel your clients that a top up option is “standard” in tender offers that you ask a junior associate for the cap table, first.  It’s important to make sure the target has enough authorized stock so that it’s possible to grant the option.  Although it doesn’t sound like a lot, in actuality the target will have to issue a lot of stock to move from say 88% to 90% and thus be in a position to conduct a short form merger. 

I was surprised how far short of the statutory 80% Apax fell in its tender for Bankrate. If it’s true that they got just over 50%, then Bankrate had to have the printing presses working overtime to issue all the new stock required to get Apax over the 80% line (I know, I know, no stock certificates were actually printed…).

In Bankrate’s case that turned out not to be a problem.  It had 100 million shares authorized, of which only 19,148,003 were issued and outstanding (see the cap rep).  Assuming the tender closed with 50% tendering their shares (957,400 shares), then Bankrate would have to issue an additional 28.7 million shares to increase the buyer’s holdings from 50% to the 80% required (in Maryland) to conduct a short-form merger.*  That’s a lot of stock.  Prior to the tender, Bankrate only had 19 million shares outstanding.  In order to get Apax in a position to conduct a short form merger, it would have to issue something like 150% of its outstanding shares.  In Bankrate’s case they had plenty of authorized but unissued stock, but that may not always be the case, so it’s worth pulling out a calculator and checking.

Of course, in issuing such a large block of stock you’ll blow through listing standards that require stockholder votes (on issuances equal to >20% of outstanding shares). But, I suppose if you are taking a company private such things as listing standards don’t prevent much of an obstacle.  I mean, what is the NYSE going to do?  Delist you?

-bjmq

* Assuming that Apax received 50% of the outstanding shares in the tender, the math goes something like this:  

(9,574,003 Apax tendered shares + 28,722,005 Apax option shares)/(19,148.003 old shares outstanding + 28,722,005 option shares) = 80.0%

Time to Rethink M&A?

"It's high time we stand back and completely revamp the basic terms of M&A papers, eliminating the boilerplate that is never relevant in the real world and advancing concepts that actually work when markets turn or expectations change. The technology for this -- reverse breakup fees, ticking fees, deposits and the like -- has been around for a while, but it is not used nearly as much as it should be or nearly as effectively as it could be."   So says Robert Profusek over at The Deal.

-bjmq

What must a Board do to satisfy its Revlon duties?

Milbank, Tweed reviews the decision of the Delaware Court of Chancery in Police & Fire Ret. Sys. of the City of Detroit v. Bernal, et al. and concludes

 [The Delaware Supreme Court’s recent decision in Lyondell Chemical Company v. Ryan] confirmed that directors may aggressively pursue a transaction that they determine in good faith to be beneficial to shareholders, despite the absence of an auction process, so long as their actions are reasonable and aimed at obtaining the best available price for shareholders. However, . . . the language used by the Court in Bernal certainly suggests that when a company has attracted more than one bidder, the best way for a board to satisfy its Revlon duties and maximize shareholder value is to follow a robust sale or auction process that avoids taking actions that could be perceived as favoring one bidder over another. As Court of Chancery decisions in recent years have demonstrated, when only one bidder exists, Delaware Courts are reluctant to upset the deal and risk losing an attractive opportunity for target company shareholders. In contrast, when more than one bidder is involved, Delaware Courts are more comfortable scrutinizing a deal and taking steps to permit an auction to continue.

Get the full story here.

 

MAW

Matching Rights in Merger Agreements

Rights of first refusal in merger agreements are a little bit of a hobby horse of mine.  Except for papers by David Walker (here) and another by Marcel Kahan (here) they don’t get much attention.  This is always a bit surprising to me.  In the Deals class, the incentive effects of rights of first refusal take up a full class period, but yet there isn’t much attention given them.  Maybe they don’t get much attention because their incentive effects are so obvious.

I take that back.  Match rights were a central argument in the Toys R Us case.  But there Vice Chancellor Strine evaluated the expert opinions of Prof. Guhan Subramanian and Prof. Prescott McAfee and found their conclusion – that the presence of a match right can/should dampen the effects of a competitive auction by deterring potential second bidders – lacking.  In fact, he noted that examples of matching rights in merger agreements “are simply not that unusual.”  He’s right on that mark.  Matching rights in merger agreement are pervasive.  In some research I have percolating on matching rights in merger agreements, I found that the vast majority of the merger agreements in my sample had one form or another of a matching right.  So, Vice Chancellor Strine is right so far as that goes.  On the other hand, I found that transactions with matching rights also had statistically significant lower prices.    [An aside: It looks like Toys just announced an acquisition of FAO Schwarz today.]

However, because matching rights come in a variety of flavors – from weak to strong – they are a coding nightmare.  For example, take a look at the matching right at question in the Toys case (merger agreement here):

6.5 Acquisition Proposals … (b) Notwithstanding anything in this Section 6.5 to the contrary, … the Company may terminate this Agreement and/or its Board of Directors may approve or recommend such Superior Proposal to its stockholders …;  provided, … however, that the Company shall not exercise its right to terminate this Agreement and the Board of Directors shall not recommend a Superior Proposal to its stockholders pursuant to this Section 6.5(b) unless the Company shall have delivered to Parent a prior written notice advising Parent that the Company or its Board of Directors intends to take such action with respect to a Superior Proposal, specifying in reasonable detail the material terms and conditions of the Superior Proposal, this notice to be delivered not less than three Business Days prior to the time the action is taken, and, during this three Business Day period, the Company and its advisors shall negotiate in good faith with Parent to make such adjustments in the terms and conditions of this Agreement such that such Acquisition Proposal would no longer constitute a Superior Proposal.

There is a three day matching period that’s not uncommon.  What is less common and gives this right of first refusal its real teeth is the requirement that Toys negotiate in good faith with the initial bidder until such time as the second bid no longer constitutes a superior proposal.  This type of match right (the ‘good faith negotiation right’) is the strong form. There are weaker forms.

For example, in AMD’s acquisition of Broadcom last year, the parties included the mildest form of a matching right – ‘information rights.’  Here’s the relevant language (merger agreement):

4.2 No Solicitation (b) … In addition to the foregoing, if … Seller or any of its Representatives receive any Competing Proposal or Inquiry, Seller shall immediately notify Purchaser thereof and provide Purchaser with the details thereof, including the identity of the Person or Persons making such Competing Proposal or Inquiry, and shall keep Purchaser fully informed on a current basis of the status and details of such Competing Proposal or Inquiry and of any modifications to the terms thereof, in each case to the extent not prohibited by a confidentiality, nondisclosure or other agreement then in effect and entered into prior to the date hereof …

This language places no obligations on the seller other than to keep the initial bidder fully informed.  Presumably a fully informed initial bidder that is actively interested in completing a purchase will be able to use such information to engage in ongoing negotiations and match any other offer on the table.  Still, information rights are the weakest form of matching right – mostly because there is no “right” involved. 

There is another matching right solution.  This involves a combination of information rights and a delay before the seller is permitted to terminate the agreement, change its board recommendation, or have its board meet to consider a superior proposal – a ‘delayed termination right’.  For example, you can find an example in the D&E Communications transaction (merger agreement here).

6.2 No Solicitation of Transactions … (4)  f)      Notwithstanding the foregoing, at any time prior to obtaining the Company Shareholder Approval …, the Board of Directors may (x) make a Company Adverse Recommendation Change or (y) cause the Company to terminate this Agreement pursuant to Section 8.4(b) if: …  the Company delivers written notice to Parent (a “Notice of Superior Competing Transaction”) advising Parent that the Board of Directors intends to take such action and specifying the reasons therefor, including the material terms and conditions of any Superior Competing Transaction that is the basis of the proposed action by the Board of Directors (it being understood and agreed that any amendment to the financial terms or any other material term of such Superior Competing Transaction shall require a new Notice of Superior Competing Transaction and a new five Business Day period), and after the fifth Business Day following delivery of the Notice of Superior Competing Transaction to Parent the Board of Directors continues to determine in good faith that the Competing Transaction constitutes a Superior Competing Transaction …

In the example above, the initial bidder gets information rights combined with a 5 day delay during which time the initial bidder can presumably negotiate its way back into the picture. 

Or, what the heck, you could just draft a match right that all elements of the above – below is Sumtotal Systems recent agreement (merger agreement) that includes information rights, good faith negotiation rights and a delayed fuse on both termination and a board recommendation.

5.3 No Solicitation (f) (iv) in the case of clauses (x) and (y) above, (A) the Company shall have provided prior written notice to Newco at least three (3) Business Days in advance (the “Notice Period”), to the effect that absent any revision to the terms and conditions of this Agreement, the Company Board has resolved to effect a Company Board Recommendation Change and/or to terminate this Agreement pursuant to this Section 5.3(f), which notice shall specify the basis for such Company Board Recommendation Change or termination, including in the case of Section 5.3(f)(y) the identity of the party making the Superior Proposal, the material terms thereof and copies of all relevant documents relating to such Superior Proposal; and (B) prior to effecting such Company Board Recommendation Change or termination, the Company shall, and shall cause its financial and legal advisors to, during the Notice Period, (1) negotiate with Newco and any representative or agent of Newco (including, without limitation, any director or officer of Newco) (collectively, “Newco Representatives”) in good faith (to the extent Newco desires to negotiate) to make such adjustments in the terms and conditions of this Agreement such that the Company Board would not effect a Company Board Recommendation Change and/or terminate this Agreement, and (2) permit Newco and the Newco Representatives to make a presentation to the Company Board regarding this Agreement and any adjustments with respect thereto (to the extent Newco desires to make such presentation); provided, that in the event of any material or substantive revisions to the Acquisition Proposal that the Company Board has determined to be a Superior Proposal, the Company shall be required to deliver a new written notice to Newco and to comply with the requirements of this Section 5.3 (including this Section 5.3(f)) with respect to such new written notice

 

The effect of all of these common provisions is to reinforce the position of the initial bidder and dissuade second bidders unless the second bidder has a private valuation that it believes is substantially higher than the private valuation of the initial bidder.  I’ll post some more thoughts on matching rights another day.

- bjmq

 

Update:  I've posted a draft of my paper (Match That!: An Empirical Assessment of Rights of First Refusal in Merger Agreements) on SSRN.  It includes data from from my review of transactions with rights of first refusal, etc.

Huntsman/Hexion

Huntsman Chemical is trading below its August lows today.  As we all know, Huntsman currently has agreed to be acquired by Hexion Specialty Chemicals Inc., a portfolio company of Apollo.  At first blush, it appears that Hexion pulled a nice trick -- negotiating a private equity type agreement for a strategic combination.  Huntsman countered with an Avaya-type model -- demanding specific performance of the financing and a reverse termination fee of $325 million.  That is the public perception.  But given the recent trading lows of the stock I thought I would take a second look at the merger agreement.  It turns out the public perception is not all correct. 

Let's start with Section 7.4 -- which is specific performance of the financing arrangements.  It states:

Financing Breach. In the event that (i) Parent and Merger Sub are in compliance with the terms of Section 5.12 of this Agreement, (ii) the terms and conditions set forth in the Commitment Letter with respect to the Financing (or the definitive documentation entered into with respect to any Alternate Financing obtained in the manner provided in, and consistent with the terms of, Section 5.12) have been satisfied and (iii) one or more of the financing institutions obligated to provide a portion of the Financing (or such Alternate Financing) fails to provide its respective portion of such financing and, as a result, the Closing does not occur, Parent and Merger Sub shall, upon the request of the Company, promptly commence a litigation proceeding against any breaching financial institution or institutions in which it will use its best efforts to either (x) compel such breaching institution or institutions to provide its portion of such financing as required or (y) seek from the breaching institution or institutions the maximum amount of damages available under applicable law as a result of such breach. Parent and Merger Sub further agree that any amounts received by Parent and Merger Sub in settlement or resolution of any such proceeding, net of any reasonable fees and expenses incurred by Parent and Merger Sub in connection with any such proceeding, shall be paid to the Company promptly following receipt thereof by Parent and Merger Sub; provided, that if such recovery is obtained prior to the termination of this Agreement in accordance with its terms, Parent shall, subject to the other terms and conditions contained herein, complete the Merger and the other transactions contemplated by this Agreement.

This is nice language -- it specifically requires Hexion and Merger Sub to go after the financing banks to fund the transaction and use their best efforts to do so (a standard which is higher than the reasonable best efforts required of Finish Line in its merger agreement and generally has been interpreted to require all actions short of bankruptcy).  M&A lawyers negotiating private equity deals on the sell-side would do well to include this language. 

Here is where it gets murky.  Section 8.11 of the merger agreement state: 

In circumstances where the Parent and Merger Sub are obligated to consummate the Merger and the Merger has not been consummated on or prior to the earlier of the last day of the Marketing Period or the Termination Date (other than as a result of the Company’s refusal to close in violation of this Agreement) the parties acknowledge that the Company shall not be entitled to enforce specifically the obligations of Parent or Merger Sub to consummate the Merger; provided, that notwithstanding the foregoing, it is agreed that the Company shall be entitled to enforce specifically the Parent’s and Merger Sub’s obligation to draw upon and cause the Financing to be funded if the conditions set forth in Section 6.1 and Section 6.2 have been satisfied (other than conditions which by their nature cannot be satisfied until Closing) and the funds contemplated by the Financing or any Alternate Financing shall be available.

Read this a few times.  I read it to say that Huntsman can force Hexion to draw on the financing but cannot be required to consummate the transaction!? Can this be -- Hexion would likely counter argue that this only applies if you are at the end of the marketing period or the termination period (April 5, 2008 though extendable).  Before we make any conclusions, let's see if any other provisions of the merger agreement shed light on this. Section 7.3(f) of the merger agreement contains the general cap on monetary damages.  It states:   

Section 7.3(f) Notwithstanding anything to the contrary in this Agreement, the parties agree that the monetary remedies set forth in this Section 7.3 and in Section 7.4 and the specific performance remedies set forth in Section 8.11 shall be the sole and exclusive remedies of (A) the Company and its Subsidiaries against Parent and Merger Sub and any of their respective former, current or future general or limited partners, stockholders, managers, employees, representatives, members, directors, officers, Affiliates or agents for any loss suffered as a result of the failure of the Merger to be consummated except in the case of fraud or with respect to Parent and Merger Sub only, a knowing and intentional breach as described in Section 7.2(b), and upon payment of such amount, none of Parent or Merger Sub or any of their respective former, current or future general or limited partners, stockholders, managers, employees, representatives, members, directors, officers, Affiliates or agents shall have any further liability or obligation relating to or arising out of this Agreement or the transactions contemplated hereby except in the case of fraud or, with respect to Parent and Merger Sub only, a knowing and intentional breach as described in Section 7.2(b); and (B) Parent and Merger Sub against the Company and its Subsidiaries and any of their respective former, current or future stockholders, managers, employees, representatives, members, directors, officers, Affiliates or agents for any loss suffered as a result of the failure of the Merger to be consummated except in the case of fraud or with respect to the Company and its Subsidiaries, a knowing and intentional breach as described in Section 7.2(b) but subject to the terms of Section 8.10, and upon payment of such amount, none of the Company and its Subsidiaries or any of their respective former, current or future stockholders, managers, employees, representatives, members, directors, officers, Affiliates or agents shall have any further liability or obligation relating to or arising out of this Agreement or the transactions contemplated hereby except in the case of fraud or, with respect to the Company and its Subsidiaries, a knowing and intentional breach as described in Section 7.2(b) but subject to the terms of Section 8.10.

So, the limitation on liability is made subject to Section 8.11 at the beginning.  This is the type of drafting that got Cerberus into so much trouble.  Section 8.11 is the specific performance clause and it is set forth above.  Go back and read it.  It only requires specific performance of the financing.  Again, quite a circularity.  But here before we start panicking Section 7.2(b) saves the day.  It states:

(b) In the event of termination of this Agreement by any party hereto as provided in Section 7.1, this Agreement shall forthwith become void and there shall be no liability or obligation on the part of any party hereto except with respect to this Section 7.2, the fifth and sixth sentences of Section 5.2, Section 7.3, Section 7.4 (if applicable) and Article VIII; provided, however, that no such termination (or any provision of this Agreement) shall relieve any party from liability for any damages (including, in the case of the Company, claims for damages based on the consideration that would have otherwise been payable to the stockholders of the Company, and, in the case of Parent and Merger Sub, claims for damages based on loss of the economic benefits of the transaction) for a knowing and intentional breach of any covenant hereunder.

So, actually, the agreement is a pretty tight one.  It requires that Hexion use its best efforts to  enforce the commitment letters and reasonable best efforts to replace that financing if it is unavailable.  But what if Hexion can't get the financing even if it does use such efforts?  Is it still obligated to close? Here  there is no financing condition -- the question would be whether in light of the fulfillment of all of the conditions, the refusal to close would be a breach and though Huntsman would lose the deal it could still collect damages.  I see no other provisions on the agreement on this, so it certainly appears to be a good argument for Huntsman.  All private equity deals should be this tight.   

Addendum:  Note the deal is also unusual in that it provides for the funding of the deal pre-closing into a payment fund.  Huntsman's condition to closing is predicated on the payment of the merger consideration into the payment fund (see Section 6.3(d). 

URI: The Specific Performance Issue

Kevin Miller, an excellent M&A lawyer at Alston & Bird, has a post up on DealLawyers.com concerning the possibility of specific performance being ordered in the URI case.  You can read the full post by clicking here, but what follows is the gist of his argument:

URI's brief fails to justify specific performance for two reasons, both relating to the alleged harms it claims: (i) the defendants' failure to pay the agreed cash merger consideration and (ii) the decline in the value of URI shares as a result of the defendants' allegedly manipulative disclosures.

First, to the extent the alleged harms solely relate to the fact that URI's shareholders will not receive the agreed cash merger consideration or that the value of the URI shares they hold has declined, money damages would appear to be a practicable and therefor more appropriate remedy. URI voluntarily agreed to a cap on money damages - and should not now be permitted to claim that money damages are inadequate as a remedy because of that agreed limitation.

Second, and more importantly, the alleged harms are not harms to URI. They are only harms to URI's shareholders who are not third party beneficiaries under the merger agreement and are consequently not entitled to protection or relief against such harms (see Consolidated Edison v. Northeast Utilities, 426 F.3d 524 (2d Cir. 2005) applying New York law and holding that shareholders cannot sue for lost merger premium; see also Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004) applying Delaware law in analogous circumstances).

I don't agree with Mr. Miller's argument and believe that specific performance is available here if URI wins on its contract claims for the following reasons:

1. Mr. Miller's argument doesn't make logical sense.  In Mr. Miller's world, Chandler agrees with URI's interpretation of the merger agreement that specific performance is required under 9.10.  In other words, Chandler finds that the last sentence of section 8.2(e) limiting URI's rights to damages in the amount of $100 million is applicable only in cases where the merger agreement is terminated.  But then at the damages phase after deciding Cerberus to be in breach and URI to have a right of specific performance under sec. 9.10, Chandler orders that as a matter of Delaware law, damages are more appropriate.  This doesn't make sense because, if he did do this, it would mean that the $100 million guarantee limitation again kicks in leaving URI without full compensation for Cerberus's breach and giving Cerberus, the breaching party, exactly what they were asking for despite Chandler's finding of the intent of the contract.  Even if the Chancery Court were not a court of equity I doubt they would come to such an illogical conclusion.
2. Specific performance was agreed to here.  If Chandler agrees with URI's reading of the merger agreement then Cerberus specifically agreed that specific performance was permissible under sec 9.10.  In similar paradigms, the Chancery Court has held litigants to their agreement that a damages remedy was inadequate and an equitable one appropriate.  Thus in True North Communications, Inc. v. Publicis, S.A., Del.Ch., 711 A.2d 34, 45, aff'd, Del.Supr., 705 A.2d 244 (1997), the Chancery Court provided a grant of injunctive relief based on a defendant's agreement that an equitable remedy was appropriate and damages an inadequate remedy.  Here, if URI's argument is correct, it is likely the Chancery Court would bar Cerberus from arguing against specific performance due to their contractual agreement.  This is after all a court of equity. 
3. Regardless, specific performance is justified here as there is no adequate damages remedy. Mr. Miller is right that in Delaware a party is never absolutely entitled to specific performance; the remedy is a matter of grace and not of right, and its appropriateness rests in the sound discretion of the court. In general, equity will not grant specific performance of a contract if it cannot “effectively supervise and carry out the enforcement of the order.”  Moreover, the balance of the equities must favor granting specific performance.  A remedy at law, i.e., money damages, will foreclose the equitable relief of specific performance when that remedy is “complete, practical and as efficient to the end of justice as the remedy in equity, and is obtainable as [a matter] of right.”  NAMA Holdings, LLC v. Related World Market Center, LLC 922 A.2d 417 (Del.Ch. 2007).  Here, however, a monetary damages award would be against RAM Holdings (the Cerberus subsidiary).  This is a shell company and, as the Chandler no doubt knows, would not be able to pay any amount.  Rather, again if Chandler awarded a monetary damage award URI could only collect against the $100 million guarantee issued by Cerberus resulting in URI not receiving full recompense for its damages.  Given this, it is hard to see how Chandler can find that monetary damages is a complete remedy as it again results in Cerberus winning a back door victory and URI without full compensation for Cerberus's breach -- a predicate for specific performance even without Cerberus's agreement in sec. 9.10. And, of course, such a decision would fly in the face of the parties' intent to the extent Chandler rules in URI's favor on the breach point.
4. Delaware Precedent supports the grant of specific performance.  In In re IBP, Inc. Shareholders Litigation, 789 A.2d 14 (Del.Ch. 2001), Vice Chancellor Strine found that sellers in a merger agreement were entitled to specific performance.  His decision rested in part on the ability of the sellers to elect to receive stock in the transaction (not an issue here) but also upon the fact that monetary damages would be exceedingly difficult to establish.  The latter point is applicable here even if there was not the issue of the guarantee.  There is also some good dictum in that case which supports URI's case. 
5. The fact that the URI shareholders are not a party to this agreement is not an issue. Mr. Miller's second point is contrary to established case-law.  He is arguing that URI cannot establish damages here because URI's shareholders are not a party to the agreement and are not third party beneficiaries.  But he is conflating a number of issues.  First, under basic contract law URI can itself contract for a benefit to a third party (i.e., its shareholders) and if the other party breaches, the damages remedy is generally the amount URI would have to incur to cure the breach.  So, for example, I hire a music teacher for my child and agree that they will provide lessons at $10 an hour.  If the music teacher breaches and I have to hire a new music teacher at $12 an hour, then my damages against the first music teacher are relatively clear under contract law -- it is the $2 an hour difference.  This is the case here.  The opposite outcome would mean that no contract of this type could ever be truly enforced.  Moreover, numerous cases in Del., New York and federal courts have enforced buyer obligations under merger agreements on this same rationale -- none to my knowledge has ever held Mr. Miller's position to be correct.  Mr. Miller attempts to distinguish IBP on this issue, but again I think he misses the point that Strine treated IBP and its shareholder claims as one and the same.  There appears no jusitification for any different treatment here. 
6. The third party beneficiary clause does not effect this outcome.  This is where Mr. Miller again conflates the issue.  He cites the "no third party beneficiary" clause in the merger agreement and the Con Ed. case to assert that URI has no damages claim with respect to the consideration paid to its shareholders.  But the no third party beneficiary clause and the Con Ed. case merely state that shareholders in this regard have no right to sue in their personal capacity under the merger agreement -- only the company can.  Tooley, the Delaware case he cites, says the same thing.  Here, though, URI is bringing the claim, not the shareholders -- so this is not a problem and as I stated in point 5-- URI is permitted under established case-law to bring this claim.  Again, I challenge anyone to find a case where a seller in a merger contract sues to enforce the contract and the court denies the claim because the damages remedy is to the shareholders.  There isn't one because it just doesn't jibe with basic contract interpretation laws or the parties likely intent and it just doesn't make commercial sense. 

Finally, there is one big problem on the specific performance front for URI, and that is the complexity of any such remedy.  In alternative scenarios, Delaware courts have refused to grant specific performance because it would be too complex a remedy for the court to implement.  So, in Carteret Bancorp., Inc. v. Home Group, Inc., 1988 WL 3010 (Del. Ch. 1988), the court refused to issue an injunction requiring defendants to use their best efforts to obtain required regulation approvals and, specifically, to take or refrain from taking certain identified actions in part on the grounds that it was too complex.  This may be the case here -- the remedy URI seeks is certainly a complex one.  And a weakness in URI's brief is their assumption that Chandler can fashion a specific performance remedy in this case --i.e., force Cerberus to fund the equity. I think URI has a good case in Delaware but I simply do not know what happens if they do indeed win at the Dec. mini-trial.  I suppose it all shifts up to New York with URI litigating RAM Holding's claim against Cerberus under the equity commitment letter?  But who knows, and maybe that is why URI didn't address this issue in depth -- they just don't know either.  BTW -- URI's response to Cerberus's N.Y. complaint is due 30 days after they are served (if they are served outside N.Y.) -- this is around Dec. 16 -- I suspect URI will ask Cerberus for more time to respond, though, in order to see how the Delaware action plays out. 

NB.  For those following the Genesco trial many of the principles above apply there under Tennessee law, but the matter is complicated by the solvency issue. 

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? 

Hell is Other People: Genesco/Finish Line/UBS

Background

The Genesco/Finish Line material adverse change dispute is now about as ugly as it gets.  First, early last week Genesco filed an amended complaint.  The amended complaint was largely unremarkable and unchanged from the original, although in addition to a specific performance claim, Genesco amended its complaint to include an alternative claim for damages relief (this is important -- I'll get to it below under the heading Solvency).  Later in the week, Finish Line answered.  Finish Line, now having the benefit of discovery, counter-claimed "against Genesco for having intentionally, or negligently, misrepresented its financial condition in order to induce Finish Line into entering" the transaction.  Shifting tactics, Finish Line also baldly asserted that a material adverse change had occurred to Genesco under the terms of the merger agreement.  Moreover, Finish Line asserted that "[t]his fundamental change in Genesco's financial position also raises serious doubts that Finish Line and the combined company will be solvent following the Merger."  Finish Line concluded its answer and counter-claim by stating:

As a result, Finish Line suffered injury by entering into the Merger Agreement while unaware that Genesco was in the midst of a financial free-fall, for which there still appears to be no bottom.

It actually got worse after this.  On Friday, UBS counter-claimed in the Tennessee Court.  UBS didn't assert a claim of "intentional, or negligent, misrepresentation".  Instead they threw down a counter-claim of fraud against Genesco.  Things are real bad when your ostensible banker is accusing you of fraud.  Not content with that charge, UBS also sued both Finish Line and Genesco in the Southern District of New York seeking to void its financing commitment letter since Finish Line could not deliver the solvency certificate required to close the financing.   The reason UBS asserted was that "[d]ue to Finish Line's earnings difficulties and Genesco's disastrous financial condition, the combined Finish Line-Genesco entity would be insolvent . . . . "  Clearly, Finish Line's specially hired uber-banker Ken Moelis was unable to perform his expected job of reigning in UBS.  [update here is the UBS N.Y. complaint]

This is a mess.

Material Adverse Change Clause

First, the material adverse change issue.  My first thought is that this case is a very good example of the fact-based nature of MAC disputes.  When we first looked at this deal back on August 31, I noted that I thought Genesco had a good legal case based on the tight MAC clause it had negotiated.  But I also stated that my conclusions at that time were based on the public evidence and that discovery would flesh out the validity of Finish Line's claims.  It now appears that Finish Line's claim is premising its MAC claim on Genesco's earnings drop -- a decline of 100% to $0.0 earnings per share compared to the same period from the previous year when Genesco's earnings per share were $0.24. 

As we know under Delaware law a  "short-term hiccup in earnings should not suffice; rather the Material Adverse Effect should be material when viewed from the longer-term perspective of a reasonable acquiror."  In re IBP, Inc. Shareholders Litigation (“IBP”), 789 A.2d 14 (Del. Ch. 2001).  Thus, it is interesting to note that Finish Line's only support for this assertion appears to be the following:

What is more, there is no indication Genesco's decline has bottomed out. Genesco's most recent financials instead indicate that it is poised to suffer another substantial drop in earnings in the third quarter.

Finish Line still hasn't factually asserted anything longer term than two quarters of adverse performance.  Thus, to the extent the Tennessee court adopts Delaware law on this issue, Finish Line is going to have to show at trial that this is an adverse change that is going to continue.  They have a good start with the two-quarter drop, if indeed Genesco's results announced later this month show such a drop, but at trial Finish Line will still need to prove the long term nature of this change.  Moreover, the MAC clause in the merger agreement excludes out a failure to meet projections as well as: 

(B) changes in the national or world economy or financial markets as a whole or changes in general economic conditions that affect the industries in which the Company and the Company Subsidiaries conduct their business, so long as such changes or conditions do not adversely affect the Company and the Company Subsidiaries, taken as a whole, in a materially disproportionate manner relative to other similarly situated participants in the industries or markets in which they operate;

Nowhere does Finish Line comprehensively address this argument.  My bet is, given the of-late poor performance of Finish Line itself, the definitive MAC issue at the Tennessee trial is going to revolve substantially around whether this sub-clause (B) excludes out any MAC.  Here, note the materially disproportionate requirement, something notably absent in the SLM/Flowers MAC (to their detriment).  Thus, Finish Line still has a high hurdle to meet in order to prove a MAC-- it must prove the long term nature of this claim beyond two quarters and that it is materially disproportionate to what is occurring in the industry generally.

Perhaps as a comment on the Finish Line MAC claim, UBS in its own complaint makes the following statement about the Material Adverse Change to Genesco:

UBS denies that there necessarily has been no Material Adverse Effect with respect to Genesco's business.

UBS has yet to claim a MAC occurred in the merger agreement.  And, I have not read UBS's N.Y. complaint but it appears that they have not asserted the mirror-image MAC clause in their financing commitment letter to justify not financing the deal.  Rather, their argument appears centered on fraud by Genesco and the insolvency of the combined entity. 

The one monkey-wrench here is the solvency claim which may in and of itself justify a MAC claim. 

Solvency!?

The issue had been rumored on the Street for a while, but still the solvency claim is amazing.  Finish Line is clearly frantically trying to avoid a doomsday scenario where it is required to complete the Genesco deal but lacks the financing to do so.  Thus, Finish Line claims that "[t]he ability of Finish Line and the combined enterprise to emerge solvent from the Merger is an additional condition precedent to the Merger Agreement under Sections 4.9 and 7.3."  However, Section 4.9 is Finish Line's own representation to Genesco as to its solvency post-closing.  Section 7.3 is the condition that Finish Line's own representations must be true in order for Finish Line to require Genesco to close.  But, Genesco can waive this condition and the breach of this representation!  Moreover, Finish Line appears to be aware of this snafu; so it also claims that if the post-combination company is insolvent it would violate Genesco's representation in 3.17 that the merger will not violate any law applicable to Genesco.  I think this final argument is a stretch -- the violative conduct would be that of Finish Line -- if the parties had wanted to pick up this type of conduct they would have had Genesco make the representation rather than Finish Line.

Still, any judge would be loathe to order specific performance of a merger that would render the other party insolvent -- which is why I suspect Genesco is now asking for a monetary award.  This is an alternative to this issue.  Nonetheless,  I want to emphasize that any judge in the face of this insolvency may find it to be MAC.  I don't believe that this is what the MAC is intended to encompass or that the plain language is designed to address such events -- it is merely changes to Genesco.  If the parties had wanted they could have negotiated a solvency condition.  But they didn't.  Nonetheless, the event is so horrific a judge may find a way to read the MAC clause this way. 

The bottom line is that even if this combination would indeed render Finish Line insolvent, I'm not sure they get out of this agreement unless the judge stretches in interpreting the MAC clause.  There is no specific solvency condition and the agreement does not contain any specific out for such circumstances. 

Unfortunately for Finish Line, UBS has a better case to escape its financing commitments.  Under the financing commitment letter, it is a condition to closing that UBS receive:

all customary opinions, certificates and closing documentation as UBS shall reasonably request, including but not limited to a solvency certificate.

If the combined company is indeed going to be insolvent UBS can get out of its financing commitment.  But as I've said, it is unclear if Finish Line can also get out of its own agreement.  Given this, Finish Line must clearly be desperate to raise this issue in its own filings.  But I suppose it has nothing to lose at this point. 

Financing

It is at this point that I will quote Finish Lines representation at Section 4.6:

For avoidance of doubt, it shall not be a condition to Closing for Parent or Merger Sub to obtain the Financing or any alternative financing.

While I tut-tut the lawyers for putting this as a representation (it is more appropriate to include as a covenant or in the conditions to closing), it bears repeating that there is no financing condition in this merger agreement. 

As an aside, in Section 6.9 Finish Line agrees that: 

In the event any portion of the Financing becomes unavailable on the terms and conditions contemplated in the Commitment Letter, Parent shall use its reasonable best efforts to arrange to obtain alternative financing from alternative sources in an amount sufficient to consummate the transactions contemplated by this Agreement on terms and conditions not materially less favorable to Parent in the aggregate (as determined in the good faith reasonable judgment of Parent) than the Financing as promptly as practicable following the occurrence of such event but in all cases at or prior to Closing. Parent shall give the Company prompt notice of any material breach by any party to the Commitment Letter of which Parent or Merger Sub becomes aware or any termination of the Commitment Letter. Parent shall keep the Company informed on a reasonably current basis in reasonable detail of the status of its efforts to arrange the Financing.

This doesn't mean particularly much for Genesco as there is no way that any bank is going to give financing to Finish Line on the same terms as UBS has.  Any financing will be much less favorable, so Genesco can't get much from this.  I note this only as a possible rabbit hole. 

Fraud

The fraud claim by UBS and intentional or negligent misrepresentation claim by Finish Line are much more interesting.  Finish Line alleges that: 

On top of this, by its own admission, Genesco also knew by at least early June that its second quarter projections were based on the erroneous assumption that certain state's back-to-school dates and tax holidays fell during the second quarter. Despite this, Genesco intentionally, or negligently, failed to provide Defendants, prior to execution of the Merger Agreement, with its May operating results or tell Defendants that Genesco's second quarter projections mistakenly relied on certain back-to-school dates and tax holidays occurring in the quarter.

UBS's fraud claim relies on similar non-disclosure. 

I'm going to wait and see Genesco's response before responding to this as it is a pure question of fact.  If the court finds this true, it would generally justify excusing Finish Line's performance.  The New York law on this is actually more developed -- I am not sure off-hand what the Tennessee law is.  Again, though, this is really just something that will depend on how each judge rules.  Ultimately since the Tennessee judge is ruling first, the New York one will likely follow.

But I will say this, Finish Line clearly wants out of this agreement at all cost and is playing a scorched earth policy.  It has now completely alienated the employees and officers of a company it may have to acquire.  Quite a risk and perhaps why they did not allege fraud but rather negligent misrepresentation (though again I am not up on Tennessee law on this point so there may be real differences and reasons for this -- I'll look into it). 

Bottom-Line

The bottom-line is that this deal still has a long way to go before it closes.  Although Genesco still has a decent defense against a MAC claim, the solvency and fraud claims could still strongly work to Finish Line's favor.  This is something we just don't know until we see Genesco's response, and even then much of this will be determined at trial as a question of fact.  Also, do not forget that even if Genesco wins in Tennessee, there is still now a New York action to face (and UBS can further amend its complaint there to litigate a MAC claim under N.Y. law in the financing commitment letter).  This may ultimately be Finish Line's problem but still has the potential to mean no deal for Genesco or a damages remedy it can only enforce in bankruptcy court (Finish Line's bankruptcy that is) if Finish Line is unable to enforce its financing commitment.  Of course, the lawyers could have avoided this final complexity by siting the choice of forum clauses in the financing commitment letter and the merger agreement in the same states.  M&A lawyers should take note. 

Ultimately given the risks, if I was Genesco the good business decision would be to settle this out for a lump sum payment -- but the parties appear too intractable at this point for such a disposition.  Though there is a very real scenario here where Genesco actually ends up controlling Finish Line -- talk about payback. 

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.