At its heart, the decision in Hexion Specialty Chemicals, Inc. v. Huntsman Corp. (2008 Del. Ch. LEXIS 134 (Del. Ch. Sept. 29, 2008)) serves primarily as a reminder of certain fundamental principles that dealmakers should keep in mind when negotiating and executing buy-out transactions.
A merger agreement sets forth the rights and responsibilities of each party to the transaction and, in some cases, establishes what it will cost to get out of the arrangement. As the target company, Huntsman’s obligation was essentially to deliver a business that met certain expectations, defined by the representations and warranties in the merger agreement and circumscribed by the general principle of Material Adverse Effect. On the other hand, as the acquiring company, Hexion’s primary obligation was to use reasonable best efforts to consummate the transaction.
Material Adverse Effect – Hexion sought a declaratory judgment that Huntsman had suffered a Material Adverse Effect as a result of deterioration in its financial results and other factors. If the Court had found a Material Adverse Effect, Hexion would have been entitled to walk away from the merger agreement without paying a $325 million termination fee.
In finding that Huntsman had not suffered a Material Adverse Effect as defined in the merger agreement, the Court held that in order to constitute a Material Adverse Effect as typically drafted, there must be an impact on the Company that is “consequential to the company’s long-term earnings power over a commercially reasonable period” of “years, not months.” Moreover, the Court imposed on Hexion the burden to prove that a Material Adverse Effect occurred, adding that the “Buyer faces a heavy burden when it attempts to invoke a material adverse effect clause in order to avoid its obligation to close.” The opinion suggests that this result may have, in part, been driven by the fact that in this case the Buyer was the party seeking a declaratory judgment that a Material Adverse Effect had occurred.
More importantly, however, Hexion provides that, unless the definition of Material Adverse Effect specifically incorporates a concept of prospects, or the agreement otherwise indicates that prospects should be considered, the failure to meet forecasts will not serve as a basis for finding the occurrence of a Material Adverse Effect, especially where the merger agreement disclaims the parties’ ability to rely on projections or other information not specifically addressed by the representations and warranties. This was true even though the closing condition in the Huntsman agreement incorporated the phrase “has had or is reasonably expected to have… a Company Material Adverse Effect.” The Court did, however, state that the occurrence of a Material Adverse Effect could take into account the expected future performance of the target company compared to historical performance. Within this context, it is worth remembering that the Court expressed skepticism with respect to the projections prepared by both sides, leaving the question of how these results are measured very much up in the air.
Knowing and Intentional Breach – Huntsman asked the Court to order Hexion to specifically perform its obligations under the merger agreement – including its obligation to use reasonable best efforts to obtain financing. Huntsman also claimed that Hexion’s actions (including obtaining an “insolvency opinion” from Duff & Phelps) constituted a “knowing and intentional breach” of the merger agreement – in which case Huntsman’s damages would not be capped at $325 million.
The Court held that it could not order Hexion to close the merger because the merger agreement provided that specific enforcement did not extend to Hexion’s obligation to consummate the merger. However, it did find that Hexion had “knowingly and intentionally” breached the provisions of the merger agreement – including those that prohibited Hexion from taking any action that “could reasonably be expected to materially impair, delay or prevent consummation” of the financing – and ordered specific performance of all of Hexion’s obligations other than the obligation to close.
In finding that Hexion’s breach was “knowing and intentional,” the Court held that a “knowing and intentional” breach is a deliberate act which constitutes “a breach of the merger agreement, even if the breaching was not the conscious object of the act” (emphasis added). In other words, a party need only know that it is taking an action and not necessarily that the action itself constitutes a breach of the agreement. Specifically, the Court found that obtaining (and publicizing the receipt of) the Duff & Phelps insolvency opinion, as well as failing to confer with Huntsman after becoming concerned with the potential insolvency of the combined company, both constituted a failure to use reasonable best efforts and showed a lack of good faith. As a result, the Court held that the liquidated damages cap in the merger agreement was not applicable and that Huntsman would be entitled to any damages it could prove were proximately caused by Hexion’s breach.
Lessons for Dealmakers – In sum, while Hexion is notable both for its intriguing fact pattern and the predicament faced by the parties, the lessons dealmakers can take away from this decision and the other disputes surrounding the transaction are relatively simple:
- Limitations on liability should be carefully considered and formulated. Principals should not view the inclusion of a “termination fee” and limited liability provision as creating an “option,” particularly where there are also provisions providing that the target company is entitled to specific performance of preclosing covenants or if there is an exclusion from the limited liability provisions for intentional breaches. The Hexion Court allowed Huntsman to sidestep the liquidated damages provision based on such an exclusion. While the Court did not address the validity of a provision that purports to limit liability in the event a party is found to have intentionally breached its obligations or acted in bad faith, these provisions should be enforceable as between sophisticated parties.
- Courts will critically examine the motivations of parties trying to excuse their own performance. If concerns arise during the pendency of a transaction, a Buyer may generally consider and seek to protect its own interests so long as it continues to abide by the terms of the agreement and does not take actions designed to frustrate the closing.
- In leveraged transactions, unless the limitations on liability are absolute, the fact that financing providers may not be required to fund because of potential insolvency will not excuse performance by a Buyer unless the merger agreement includes a parallel solvency condition or financing condition. A Material Adverse Effect is, of course, an independent basis for not closing.
- A merger agreement and related debt commitment are obviously interdependent, particularly if the merger agreement does not have a financing out. Ideally, the conditions in the two documents would be identical, but that goal is often difficult to achieve. Accordingly, the Buyer must carefully evaluate the risks of any lack of coordination between the documents. Where there are differences, it is especially important for a Buyer seeking to excuse its performance under the merger agreement to think through its chosen strategy and how that strategy will impact all aspects of the transaction. While the Hexion Court refused to rule on the issue of solvency because that question is only relevant at the time of closing, a New York State trial court refused to extend the termination date under Hexion’s commitment letters with its funding banks – leaving Hexion in the difficult position of losing its financing and being found in breach of the merger agreement.
- Where a private equity fund is effecting an acquisition through an existing portfolio company, and the agreement does not cap the Buyer’s exposure for breach the potentially significant liability arising out of being found to have intentionally violated an acquisition agreement can threaten to bankrupt the portfolio company.
- Fundamentally, Hexion makes clear that parties to merger and acquisition transactions can draft provisions that reflect their business understandings and agreed risk allocations and the Court’s job is to interpret the agreement.