The recent Hexion v. Huntsman decision by the Delaware Court of Chancery addresses several significant issues that companies and their counsel should take into account when drafting transaction agreements. --------------------------------------------------------------------------------

On September 29, 2008, the Delaware Court of Chancery issued an opinion refusing to allow Hexion Specialty Chemicals, Inc., owned primarily by private equity firm Apollo Global Management, LLC, to terminate its merger agreement with Huntsman Corporation, a global manufacturer and marketer of chemical products. In an 89-page opinion by Vice Chancellor Stephen P. Lamb, the court held that Huntsman had not suffered a material adverse effect, and that Hexion “knowingly and intentionally” breached its covenant in the merger agreement that it would use “reasonable best efforts” to consummate financing for the deal, in fact acting to ensure that it would be unable to secure financing. The court granted specific performance to Huntsman to the extent permitted under the merger agreement, “requiring Hexion to perform all of its covenants and obligations (other than the ultimate obligation to close).”

The dispute stemmed from a merger agreement between the two chemical companies negotiated in July 2007, in which Hexion agreed to pay $28 per share for 100 percent of Huntsman’s stock, a $10.6 billion transaction that would have produced one of the largest chemical companies in the world. The terms of the agreement did not include a “financing out,” preventing Hexion from being excused from performance if it was unable to obtain adequate financing by closing. Accordingly, Hexion covenanted to use its “reasonable best efforts” to take all actions and do all things “necessary, proper or advisable” to consummate financing. The agreement further provided that if Hexion committed a “knowing and intentional breach” of this covenant, damages would be uncapped, while for any other breach they would be limited to $325 million.

After Huntsman reported several disappointing quarterly results, Hexion hired a well-known valuation firm to assess the solvency of the combined entity. When the valuation firm opined that the combined entity would not be solvent, Hexion issued a press release claiming that it was unable to obtain financing, as Huntsman had suffered a material adverse effect (MAE), as defined in the agreement, and the resulting entity would be insolvent.

In June 2008, Hexion filed suit, seeking a declaratory judgment that (i) it would not be obligated to close if the resulting company would be insolvent; (ii) Huntsman suffered an MAE by materially underperforming its industry peers and failing to meet projections; and (iii) it had satisfied its interim covenant to use reasonable best efforts to secure the financing for the transaction and, as a result and absent an MAE, its liability for failing to obtain financing to close the transaction was capped at $325 million. Huntsman, in turn, counterclaimed, asking the court to order Hexion to specifically perform its obligations under the merger agreement. 

No MAE Suffered 

Hexion based its argument that Huntsman had suffered an MAE on Huntsman’s disproportionately poor financial performance during the second half of 2007 and the first half of 2008 in comparison to other similarly situated companies in the same industry. The court rejected this argument, noting that the argument presumed an MAE had in fact occurred. Instead, the court reinforced the holding from In re IBP, Inc. Shareholders Litigation that, in order to prove an MAE has occurred, a party must show that “there has been an adverse change in the target’s business that is consequential to the company’s long-term earnings power over a commercially reasonable period, which one would expect to be measured in years rather than months.” The fact that Delaware courts have never found an MAE to have occurred in the context of a merger agreement, the court said, was no coincidence, as only “durationally-significant” events, not a “short-term hiccup,” would constitute an MAE. As in IBP, the court held that a strategic acquirer such as Hexion can be assumed to be purchasing Huntsman as part of its long-term strategy, and that the degree of Huntsman’s underperformance and failure to meet forecasts was not sufficient to constitute an MAE. The court rejected Hexion’s argument that Huntsman had the burden of proof to demonstrate the absence of an MAE and held that, absent clear language to the contrary, the buyer had the burden to show the existence of an MAE.

It is notable that while in IBP the Delaware Court of Chancery was interpreting a provision in a contract governed by New York law rather than Delaware law, the court has since held that IBP principles govern contracts under Delaware law as well. The court’s reliance on IBP in Hexion reaffirms the court’s belief that there is no material difference between New York law and Delaware law with respect to determining whether an MAE has occurred.

Hexion’s Knowing and Intentional Breach of Covenants Results in Uncapped Damages

The court likewise denied Hexion’s request for a declaratory judgment that it had not committed a “knowing and intentional” breach of the merger agreement, which would have capped its liability at $325 million. In a noteworthy discussion that will likely bear influence on future contract drafting, the court analogized the merger agreement’s breach standard to criminal law, reasoning that “[i]f one man intentionally kills another, it is no defense to a charge of murder to claim that the killer was unaware that killing is unlawful.” Similarly, Hexion need not have actual knowledge that its actions breached a covenant; rather, it need only have taken a “deliberate act” in breach of a covenant.

Hexion’s Failure to Use “Reasonable Best Efforts” to Close the Deal

Having thus defined “knowing and intentional,” the court found that Hexion failed to use “reasonable best efforts” to obtain financing for the merger. The court held that Hexion was obligated under the merger agreement to take any act that “was both commercially reasonable and advisable to enhance the likelihood of the consummation of the financing.” Instead, the court found that Hexion acted to avoid the consummation of the financing, thereby committing a knowing and intentional breach of its covenant.

Specifically, the court said, Hexion breached its covenant under the merger agreement both by failing to act by not approaching Huntsman management to discuss possible ways to address the solvency issue, and by affirmatively acting to “scuttle” the financing. Upon receiving the insolvency opinion, Hexion had a clear obligation under the merger agreement to discuss the appropriate course of action with Huntsman, and to put Huntsman on notice of its concerns. Instead, Hexion’s board adopted the findings of the insolvency opinion, filed suit and sent a copy of the opinion to the lead lending bank, which effectively prevented consummation of the financing. In addition, the court found that Hexion was intentionally “dragging its feet” in obtaining antitrust clearance from the Federal Trade Commission (FTC) pending outcome of its attempt to obstruct financing, in further violation of its covenants under the merger agreement.

Hexion further argued that a reasonable best efforts covenant does not prevent a company from seeking expert advice to assess its own future insolvency, nor from taking actions to prevent that insolvency, including, in this case, actions to terminate the merger. The court agreed with this basic contention, but noted that regardless Hexion must first take all commercially reasonable steps to meet its obligations under the merger agreement. Here, that meant: (i) taking affirmative action to obtaining financing, (ii) notifying Huntsman of its concerns and (iii) pursuing antitrust clearance from the FTC. Only if Hexion had followed this course of action, the court said, and still believed in good faith that insolvency would ensue, could it take affirmative steps to avoid such insolvency by terminating its agreement with Huntsman.

Specific Performance Granted, but Limited

Finally, the court ordered Hexion to specifically perform its covenants and obligations under the merger agreement, but did not require Hexion to consummate the merger. While the agreement provided generally that a non-breaching party could seek and obtain specific performance for breaches of the other party’s covenants, it also contained what the court stated was a “virtually impenetrable” provision wherein the parties agreed that Huntsman would not be entitled to specifically enforce Hexion’s obligation to consummate the merger. Huntsman argued that in order to have meaning, such provision could apply only prior to or during the debt marketing period but not after such period had passed or the termination date under the merger agreement had arrived. The court disagreed and found that the “inartfully” drafted provision simply did not support the argument. Accordingly, Hexion remained free to refuse to close, subject only to damages if such refusal constituted a breach of contract.

The court’s limitation on Huntsman’s specific performance remedy in this manner, however, does little to help Hexion. Having already interpreted “knowing and intentional” to include Hexion’s breach, the court precluded the $325 million damages cap from applying. Hexion is thus left with few options: it is forced to either obtain financing and proceed with the merger, or be subject to uncapped damages. Such damages, under the merger agreement, stand to be substantial, as they would amount to the difference between Huntsman’s current stock price and the $28 per share agreed to by Hexion, multiplied by the number of outstanding shares of Huntsman stock.

Lessons from Hexion

Hexion reinforced precedent that courts are unlikely to find that an MAE has occurred in the merger context. The court’s reliance on IBP and its emphasis on the “durational significance” of an MAE display a lack of sympathy for buyers in the current economic climate, as courts are continuing to enforce contractual obligations despite drastic changes in the market. Attempts to shift the burden of proof from the buyer require clear and unambiguous language.

“Knowing and Intentional”

The court’s interpretation of a “knowing and intentional” breach holds particular importance, indicating a need to reassess the use of this phrase in contract drafting. Vice Chancellor Lamb points out that the phrase has no roots in contract law, turning to criminal and tort law analogies to advance his interpretation, and ultimately adopting Black’s Law Dictionary’s definition of “knowing” as “deliberate.” Presumably, because of the nature of contract law, parties can expressly change the interpretation of any clause; future drafters are not bound by this interpretation. Nonetheless, deal lawyers must be aware that the court adopted this seller-favoring definition, which will govern in the absence of an express alternative definition.

“Reasonable Best Efforts”

The court’s scrutiny of Hexion’s behavior leading up to its filing of the lawsuit serves as a reminder of the importance of documenting all efforts to satisfy closing conditions. The court not only looked at Hexion’s failure to obtain financing and its publication of the insolvency opinion, but also its failure to take other necessary steps toward closing. In particular, the court found that Hexion had been “dragging its feet” with respect to obtaining antitrust clearance, a finding that proved damaging to its case. Particularly in the merger context, it is crucial not only to take contractually obligatory steps toward closing, but also to maintain evidence of such efforts.

Specific Performance

The court’s decision to grant specific performance to Huntsman on all measures except that of ultimately closing the deal holds a final noteworthy lesson. The parties’ dispute over specific performance was reminiscent of United Rentals, Inc. v. RAM Holdings, Inc., in which the court looked to extrinsic evidence—including negotiation and drafting history—to interpret a merger agreement that was ambiguous with respect to specific performance. In Hexion, the court likewise considered parole evidence, such as the testimony of Hexion’s drafting lawyer, ultimately deferring to the “virtually impenetrable language” of one of the provisions. In both cases the merger agreements contained specific performance provisions that may have been clear as stand-alone provisions, but conflicted with other provisions elsewhere in the agreements, resulting in dispute. These cases strongly suggest that specific performance provisions must be drafted with as much specificity as possible, and must be carefully considered within the broader context of the complete agreement.