In Hexion Specialty Chemicals, Inc. v. Huntsman Corp., 2008 WL 4457544 (Del. Ch. Sept. 29, 2008), the Delaware Chancery Court, after an expedited six day trial, ruled that Hexion Specialty Chemicals, Inc. had breached various provisions of a July 2007 merger agreement. By that agreement, Hexion, which is controlled by a private equity group, had agreed to acquire Huntsman Corp. in a leveraged cash transaction at a steep price following a bidding contest. The terms of the merger agreement left Hexion with no “financing out” if it could not close due to a lack of funding. Hexion’s efforts to extricate itself from the transaction arose in connection with the continuing crisis affecting the world-wide credit markets. Hexion had sought to excuse any failure to close on its part by claiming that Huntsman’s operations had suffered a Material Adverse Effect (MAE) under the terms of the merger agreement and that the combined entity would be insolvent. Issuing its decision before the merger agreement’s October 2, 2008 termination date, the court rejected these claims in a manner that suggested it found them pretextual and ordered Hexion to specifically perform all obligations necessary to close the deal (save the obligation to actually close, which the merger agreement exempted from a specific performance remedy). This case is significant for its illustration of the approach that Delaware courts take in interpreting and applying a MAE clause when invoked to excuse performance under a merger agreement. Also notable is the finding that Hexion had breached its covenant to use its reasonable best efforts to consummate the deal, a determination that required the court to reconcile a party’s contractual duty to use reasonable best efforts to consummate a transaction with that party’s alleged perceived need to avoid insolvency. The case also demonstrates that Delaware courts will not hesitate to impose a specific performance remedy when a contract so provides, even when the consequences to one party may be ruinous.

No Material Adverse Effect

Hexion asserted that the target suffered a MAE in the period between signing and closing that excused Hexion’s obligation to close. The court stated that in the context of a merger agreement, a corporate acquirer is generally presumed to be purchasing the target as part of a long-term strategy. Thus, the adverse change in the target’s business should be consequential to its long-term earnings power over a commercially reasonable period, measured in years. A MAE clause is a “backstop protecting the acquirer from the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner.” The court also ruled that the party who invokes a MAE to avoid a closing obligation should generally bear the “heavy burden” of proof regardless of whether the MAE clause appears in the merger agreement as a representation, warranty or condition precedent. Hexion had argued that Huntsman bore the burden of showing the absence of a MAE as a condition precedent.

The court then grappled with the appropriate benchmark — EBITDA or earnings per share — to use in assessing whether changes to Huntsman’s results of business operations, post-signing, constituted a MAE. In choosing EBITDA, the court observed that an earnings per share metric is impacted by the target’s capital structure, a structure that in a cash acquisition will be replaced by one of the acquirer’s choosing. In contrast, the target’s EBITDA is independent of its capital structure. The court noted that the parties also used EBITDA in negotiating and modeling the transaction.

In applying an EBITDA analysis, the court rejected Hexion’s efforts to use Huntsman’s management’s repeated, missed EBITDA projections because the merger agreement disclaimed any representation or warranty by Huntsman with respect to any projections or forecasts. Instead, the court compared EBITDA results in each period with the results in the same period for the prior year. This showed 2007 EBITDA only 3% below 2006 EBITDA and expected 2008 EBITDA only 7% below 2007 EBITDA. While no doubt disappointing results, based on these and other EBITDA comparisons, the court declared no MAE had occurred. The court looked at the parties’ projections of 2009 EBITDA, but found the expected decline in the target’s future operating performance to be insignificant “particularly in the face of the macroeconomic challenges Huntsman has faced since the middle of 2007 as a result of increased crude oil and natural gas prices and unfavorable foreign exchange rate changes.” Ultimately, the court’s analysis showed a nominal decrease in earnings rather than a substantial, “durationally-significant” drop in earnings. In addition to changes in actual and expected EBITDA, the court examined changes in net debt and a downturn in two of Huntsman’s business divisions and found no MAE there as well. Accordingly, it rejected Hexion’s assertion that it was not obligated to close on the deal.

Failure to Use Reasonable Best Efforts

A covenant in the merger agreement required Hexion to use reasonable best efforts to consummate the financing of the deal pursuant to a commitment letter that Hexion signed with the lead banks prior to entering into the merger agreement. Funding under the commitment letter depended on Hexion’s delivery of a solvency certificate. According to the court, “to the extent the act was both commercially reasonable and advisable to enhance the likelihood of consummation of the financing, the onus was on Hexion to take that act.” The merger agreement also required Hexion to notify Huntsman within two business days if Hexion no longer believed in good faith that it would be able to draw upon the commitment letter financing.

The court found that Hexion, when it apparently become concerned that the combined entity, after giving effect to the merger agreement and commitment letter, would be insolvent, hired counsel to explore a litigation option to extricate itself from the deal. Counsel retained a valuation firm to provide guidance on the issue of insolvency and to assist in any litigation. The valuation firm delivered a formal insolvency opinion to Hexion’s board. Concluding it could rely on the report, the board authorized the immediate filing of the lawsuit against Huntsman, which included Hexion’s claim that the combined company would be insolvent. This public filing placed the commitment letter financing in jeopardy. Hexion delivered the insolvency opinion to one of the lead banks, rendering it unlikely that the banks would be willing to fund under the commitment letter. At no time prior to these events did Hexion contact Huntsman and inform it of any insolvency concerns or attempt to work with Huntsman’s management to resolve those concerns. The court found that Hexion’s conduct constituted not only a breach of the merger agreement, but a knowing and intentional one, subjecting Hexion to full contract damages rather than to damages capped by the merger agreement’s $325 million liquidated damages clause.

Hexion protested that a reasonable best efforts covenant cannot require that a company “spend itself into bankruptcy,” by preventing it or its board from assessing its own future solvency and taking reasonable actions to avoid insolvency. Although agreeing with the proposition, the court said that the right to take steps to avoid insolvency based on a good faith view that a present course is leading to insolvency does not necessarily mean that the buyer can “abandon the merger entirely before satisfying itself that there were not commercially reasonable steps it could take to meet its obligations under the merger agreement while still avoiding bankruptcy.” Here, “Hexion simply did not care whether its course of action was in Huntsman’s best interests so long as that course of action was best for Hexion.” Under these facts, it was incumbent upon Hexion to show at trial that “there were no viable options it could exercise to allow it to perform without disastrous financial consequences.” Hexion never even attempted to meet this burden. As the court noted, Hexion oddly appeared to act at all times, including at trial, under the mistaken belief that a determination of insolvency would terminate its obligations to close the deal. It even asked the court to rule on the issue of insolvency. But, as the court stressed, the merger agreement contained no “financing out” or “insolvency out.”

Specific Performance Granted

Notwithstanding the allegations of possible insolvency, the facts indicated that Hexion might still be able to present a satisfactory solvency certificate to the banks, and the lead bank indicated that it would fund if presented with such certificate. In these circumstances, the court granted Huntsman’s request for specific performance of the merger agreement except for one obligation – the obligation to actually close. In an unusual provision, the agreement exempted that obligation from a specific performance remedy. But for that exception, the court would have specifically ordered Hexion to close. Nevertheless, the prospect of an award of full contract damages will likely motivate Hexion’s decision to close.

The lesson of this case is that parties will be held to their bargains. Hexion’s apparent attempt to save itself from insolvency actually may have compounded its breach and influenced the court’s view of the equities. The decision signals that Delaware courts will be inclined to hold corporations and their management to Delaware law standards notwithstanding the pressures of a global economic crisis — an event the court largely ignored in this case.

UPDATE: Hexion is seeking to follow through with the merger and the banks who signed the commitment letter, Credit Suisse Group and Deutsche Bank, have refused to fund and are now the new targets of litigation. Recently, Hexion, which apparently obtained and presented solvency opinions to the banks, filed suit against them in the Supreme Court of the State of New York State in an effort to obtain funding under the commitment letter. Forced to seize upon the very theme which animated the Delaware Chancery Court’s decision against it, Hexion now alleges that changes in the economy, interest rate, debt markets, and business of Hexion or Huntsman do not excuse the banks from their obligations to fund the merger.