The continuing litigation of several high-profile M&A transactions run aground by the ongoing credit crisis has brought with it an unprecedented level of scrutiny on the drafting and enforceability of "deal protection" clauses in merger agreements, and the remedies available to target companies when a buyer seeks to abandon a deal. Like the decisions of the Delaware and Tennessee Chancery Courts in United Rentals, Inc. v. Ram Holdings, Inc. et al and Genesco, Inc. v. Finish Line, Inc., UBS Securities LLC et al earlier this year, the Delaware Chancery Court’s recent decision in Hexion Specialty Chemicals v. Huntsman addresses several significant issues that companies and their advisors should consider when drafting transaction agreements.
The Hexion litigation arose out of a $10.6-billion deal signed in mid-July 2007 – at the peak of the private equity-led M&A boom – in which Hexion Specialty Chemicals, Inc., a portfolio company of the private equity firm Apollo Global Management, agreed to purchase Huntsman Corporation, a publicly traded Delaware corporation and a global manufacturer of chemicals products. Huntsman had previously entered into a merger agreement with Basell AF in June 2007, but terminated that transaction following a higher bid made by Hexion.
Following Huntsman’s announcement of disappointing first quarter results in April 2008, Hexion and its legal counsel began exploring potential avenues for terminating the transaction with no or limited liability. These focused principally on (i) the possibility that Huntsman’s declining performance constituted a "material adverse effect" (MAE) under the merger agreement; and (ii) the possibility that the combined post-merger entity would be insolvent, rendering it impossible to obtain financing for the transaction. In support of this second argument, Hexion retained the services of a valuation firm and proceeded to make adjustments to the assumptions underlying its original deal model in support of an insolvency opinion. Hexion did not confer with Huntsman regarding the preparation of the opinion or the reasonableness of the assumptions underlying it.
In June 2008, Hexion publicly disclosed the insolvency opinion and immediately brought suit in Delaware seeking a declaratory judgment that, as a result of a deterioration in its operating results following entry into the transaction, Huntsman had suffered an MAE and, consequently, Hexion was not obligated to complete the transaction and had no liability to Huntsman under the merger agreement. Hexion also alleged, in the alternative, that it would not be obligated to complete the transaction if the combined company would be insolvent, and that its liability to Huntsman for failing to close for this reason would be limited to the $325-million reverse termination fee. In response, Huntsman asserted that Hexion had knowingly and intentionally breached the merger agreement, and, as a result, Hexion’s liability under the merger agreement was not limited to the $325-million reverse termination fee. Huntsman further claimed that it had not suffered an MAE and that Hexion had no right to terminate the merger agreement.
The Delaware court rejected each of Hexion’s claims for relief, finding that Huntsman had not suffered an MAE and that Hexion had knowingly and intentionally breached several of its covenants in the merger agreement. The court ordered Hexion to perform its covenants under the merger agreement, including using its reasonable best efforts to take all actions necessary to complete the transaction. In addition, the court enjoined Hexion and its affiliates from taking any further action that would impair, delay or prevent the financing of the transaction or the completion of the merger.
Like the United Rentals and Genesco decisions before it, the Hexion decision highlights two important trends. The first trend is the increasing attention being paid by sellers to "deal protection" provisions in merger agreements, including remedy clauses. Indeed, the result in Hexion is owed primarily to the seller-friendly terms negotiated by Huntsman. Under the terms of the merger agreement, there is no financing condition and Hexion is required to use its "reasonable best efforts" to complete the financing. More significantly, while Hexion’s liability for a failure to close due to an inability to obtain financing was capped at the $325-million reverse termination fee, its liability for other breaches of covenants was uncapped. This "hybrid" remedy structure marks a departure from many other private equity transactions entered into during the same period, in which the reverse termination fee is the sellers’ exclusive remedy against a buyer who seeks to abandon the deal. The second trend, not surprisingly, has been the increasing willingness of buyers seeking to exit transactions that have become economically unattractive by invoking MAE clauses. If successful, an MAE claim, would permit the buyer to walk away from the deal with no liability.
The Hexion case provides useful guidance on a number of issues of interest to dealmakers. In particular, the decision:
- confirms the high threshold for establishing the occurrence of a "material adverse effect" previously set by Delaware courts;
- confirms that the burden of proving an MAE lies with the party seeking to excuse its performance under the contract;
- provides guidance on the methodology to be used by courts in assessing whether an MAE has occurred;
- establishes an objective standard for the "knowing and intentional" breach of a contractual provision; and
- demonstrates the Delaware courts’ willingness to grant sweeping injunctive relief to require a buyer to specifically perform its obligations under a merger agreement.
MAE Clauses: Keeping the Bar High
In ruling that Huntsman had not suffered an MAE as defined in the merger agreement, the court followed its earlier decisions in IBP v. Tyson and Frontier Oil v. Holly, which held that an MAE clause can be relied on only to protect the buyer from the occurrence of "unknown events that substantially threaten the overall earnings potential of the target in a durationally significant manner." According to the court, "A buyer faces a heavy burden when it attempts to invoke a material adverse effect clause in order to avoid its obligation to close. Many commentators have noted that Delaware courts have never found a material adverse effect to have occurred in the context of a merger agreement. This is not a coincidence."
As a preliminary matter, the court confirmed that reference to the carve-outs to an MAE clause should not be made until a finding is made that an MAE has occurred at all. Similarly, the court rejected Hexion’s claim that, since the absence of an MAE was a closing condition, Huntsman should bear the burden of proving that no MAE had occurred. Instead, the court found that the form in which an MAE clause is drafted – as a representation, or warranty, or condition to closing – should not determine which party bears the burden of proving that an MAE has occurred. The court followed the reasoning in IBP that, absent clear language in the merger agreement to the contrary, this burden should generally lie on the party seeking to relieve itself of obligations under the contract.
In reviewing whether Huntsman’s deteriorating performance in the months following its entry into the merger agreement constituted an MAE, the court noted that in a cash deal where the target company’s capital structure is being replaced, earnings before interest, taxes, depreciation and amortization (EBITDA) is a more appropriate benchmark than earnings per share in examining changes in the results of a target’s business operations. The court went on to conclude that the proper approach should take into account year-over-year and quarter-over-quarter changes to the "financial condition, business or results of operations" of the target. These terms, the court noted, should be understood with reference to their meaning in Regulation S-X and Item 7 of Form 10-K, "Management’s Discussion and Analysis of Financial Condition and Results of Operations." On this basis, the court found that changes in Huntsman’s EBITDA over the relevant period fell well short of an MAE. The court noted that the expected future performance of the target company is also relevant to the MAE analysis, but again found that no MAE had occurred, even when adopting Hexion’s more pessimistic forecast.
"Knowing and Intentional": An Objective Standard
The court next addressed the question of whether Hexion’s actions in the months leading up to the trial constituted a "knowing and intentional breach" of the merger agreement. Hexion argued that for a breach to be "knowing and intentional" the breaching party must have actual knowledge that its actions amount to a breach of contract. The court rejected this view, holding that a knowing and intentional breach is "a deliberate act, which act constitutes in and of itself a breach of the merger agreement, even if breaching was not the conscious object of the act." Applying this standard, the court found that Hexion’s actions constituted knowing and intentional breaches of Hexion’s covenants relating to, among other things, the securing of financing for the transaction and the completion of the merger. This finding is significant, since it would permit Huntsman to seek damages in excess of the $325-million reverse termination fee for any damages resulting from Hexion’s breach, and would impose on Hexion the burden to demonstrate that any particular damages were not caused by its knowing and intentional breach.
Specific Performance: Everything but the Closing
In the Hexion case, the court ordered Hexion to perform its covenants in relation to the closing of the merger, but stopped short of requiring Hexion to actually complete the transaction as this obligation was not supported by the ambiguous language in the specific performance provisions of the merger agreement. The court went on to point out that if all of the conditions to closing were met, but Hexion refused to close the transaction, Hexion would remain liable to Huntsman for uncapped damages if a refusal to close constituted a breach of the agreement.
On October 28, 2008, the banks committed to funding Hexion’s acquisition of Huntsman declared that they would not provide the required financing, notwithstanding their receipt of the required solvency opinion and officer’s certificate from Huntsman. On October 29, 2008, Hexion, seeking to ensure that it fulfilled its own obligations with respect to the financing under the merger agreement, filed suit against the banks in New York seeking specific performance of their funding obligations. On October 31, 2008, the New York court refused to grant Hexion’s motion for an extension of commitment letters from its banks, citing Hexion’s own actions, including its insolvency arguments before the Delaware court and its failure to share with lenders the solvency opinion prior to the closing date of the transaction. Hexion is appealing both the Delaware and New York decisions.
McCarthy Tétrault Notes:
Although its applicability in the Canadian context is uncertain, the Hexion case is instructive. Companies engaging in M&A activity, as well as their financial and legal advisors, should bear in mind the following points:
As in the Genesco case, the Hexion case represents an interesting development where specific performance, instead of damages, was awarded in a cash transaction. This represents a significant departure from previous case law. While injunctive relief is often specifically contemplated by the provisions of a merger agreement, it is rare for courts to award it where damages would be an adequate remedy.
Reverse Termination Fees
Buyers and sellers need to pay close attention to the implications of a given reverse termination fee structure. The favourable outcome for Huntsman in the Hexion case was due in large part to its negotiation of a more seller-friendly "hybrid" reverse termination fee — under which the reverse termination fee is the seller’s exclusive remedy only where the failure to close is due to the unavailability of financing to a buyer that has otherwise not breached the merger agreement. By contrast, where the reverse termination fee is the seller’s exclusive remedy against the buyer, the buyer is in effect given an "option" to acquire the company.
As in other broken deal litigation, the Hexion decision plainly illustrates the importance of clear, unambiguous drafting, which can be difficult to achieve in the often high-pressure, time-sensitive context of M&A negotiations:
- Specific Performance Where the remedy of specific performance is expressly retained in the merger agreement, the parties must be careful to clearly specify which obligations are covered by it and how the specific performance clause interacts with the other remedies available to the parties under the contract.
- Material Adverse Change Clauses Buyers and sellers would be well-advised to bear in mind that MAE clauses may have limited value unless appropriately and carefully drafted, and should consider the following in drafting:
- whether certain events, specified changes in operating metrics or monetary thresholds should be deemed to constitute an MAE in order to give greater certainty regarding the outcome of potential litigation
- what, if any, financial measures should be specified in assisting the parties to determine whether an MAE has occurred (in Hexion, the court determined that in a cash deal, EBITDA was a better measure of the results of the business than earnings per share, but this may not be the case for other types of transactions)
- if the parties are aware of specific events or developments – such as regulatory milestones or the renewal of key contracts – that could impact the seller prior to closing, they should clearly include or exclude these changes from the MAE definition to provide greater certainty later on. Where a specific event is known to be material, it may be preferable to draft a separate closing condition specifically covering the occurrence or non-occurrence of the event
- which party should bear the burden of establishing that an MAE has occurred or has not occurred.
- Financing Conditions As in the Genesco case, the Hexion decision highlights the importance, in the context of a private equity transaction, of the relationship between the conditions to the closing of the merger and the conditions to the closing of the merger financing. Where these are not identical, significant questions may arise regarding both the nature and extent of the buyer’s legal obligations in relation to the completion of the financing and the merger, as well as the remedies available to the seller where financing is not obtained.