On Sept. 29, 2008, in Hexion Specialty Chemicals, Inc. v. Huntsman Corp., Vice Chancellor Stephen Lamb of the Delaware Chancery Court ruled that private equity firm, Apollo Global Management, LLC (“Apollo”), and its portfolio company, Hexion Specialty Chemicals, Inc. (“Hexion” and, together with Apollo, the “Buyers”), did not have grounds to walk away from their acquisition of Huntsman Corporation (“Huntsman”) and that Hexion was required to honor its obligations under the merger agreement. The Court did not take the additional step of ordering Hexion to complete the merger because the specific performance provision in the agreement expressly carved out such obligation from its scope.
Huntsman was one of several fully signed acquisitions that were cancelled by buyers during the late spring and early summer of 2008, coincident with the advent of the current credit crisis. In most of those cancellations, the private equity sponsors claimed a material adverse change or similar occurrence, the effect of which, if upheld, would be to avoid termination fees or worse consequences from the target company. Historically, the invocation of a material adverse change condition to avoid closing an acquisition has been met with hostility by courts. The decision discussed below indicates that judicial animus to the invocation of a material adverse change has not subsided.
On July 12, 2007, Hexion and Huntsman, two leading specialty chemical manufacturers, executed a merger agreement pursuant to which Hexion agreed to acquire 100% of Huntsman’s outstanding stock for $28 per share in cash.1 The total value of the transaction was approximately $10.6 billion, including assumed debt.
The agreement did not include a financing condition. In the absence of a material adverse effect (a “MAE”) on Huntsman’s business (as defined in the agreement) or other failure of Hexion’s closing conditions from being satisfied, Hexion was required to close the merger or be liable to Huntsman for a $325 million termination fee or, in the event that Hexion intentionally and knowingly breached its obligations under the agreement, uncapped damages.2 The agreement also provided Huntsman with the right to force Hexion to draw on its financing through a specific performance clause, including the right to force Hexion to bring litigation against its committed lenders to enforce their obligations under their commitment letters and to seek from such lenders the maximum amount of damages permitted by applicable law for any such breach and to pay to Huntsman any recovered damages (net of any reasonable fees incurred by Hexion in connection with such recovery).
After the Buyers received Huntsman’s disappointing first quarter numbers in April 2008 and learned that Huntsman missed the numbers projected at the time of the deal, they began questioning whether Huntsman had suffered a MAE. Hexion hired a valuation firm, who, after receiving information from the Buyers and without any consultation with Huntsman management, furnished an insolvency opinion to the Hexion Board of Directors stating that the combined entity would be insolvent. The insolvency opinion was presented to Hexion’s Board and later published in a press release claiming that the merger could not be consummated because the financing would not be available due to the prospective insolvency of the combined entity and because Huntsman had suffered a MAE.
On June 18, 2008, Apollo and Hexion filed suit against Huntsman in the Delaware Court of Chancery seeking a declaration that 1) Hexion was not required to consummate the merger if the combined entity would be insolvent and its liability to Huntsman for failing to close the transaction was no more than $325 million; 2) Huntsman had suffered a MAE; and 3) Apollo had no liability to Huntsman in connection with the merger agreement.
On July 2, 2008, Huntsman responded by seeking an order from the Court directing Hexion to specifically perform its obligations under the merger agreement.3
The Court held that Huntsman had not suffered a MAE and that Hexion had knowingly and intentionally breached its covenants in the agreement. Hexion had asserted that Huntsman suffered a MAE in three ways: 1) disappointing results in its earnings performance from July 2007 through the present; 2) an increase in its net debt since signing, contrary to the expectations of the parties; and 3) the underperformance in its textile effects and pigments lines of business. The Court rejected each of these arguments. According to the Court, the drop in Huntsman’s earnings performance could not constitute a MAE because the merger agreement included an express disclaimer that Huntsman was not making any representation or warranty about its projections and the Court interpreted this disclaimer as precluding Hexion from claiming that a MAE had occurred due to missed projections.4 In addition, the Court noted that in only one of three scenarios in Hexion’s financial model for the transaction did Hexion assume Huntsman performing above the projections that Hexion claimed gave rise to a MAE.
The Court rejected Hexion’s argument about Huntsman’s increased net debt, even though its net debt had increased by 32%. The Court found that in all four deal models used by Hexion, it had assumed a net debt amount that was only 5% less than what it was claiming constituted a MAE. A 5% deviation from Hexion’s expectations was too small to constitute a MAE.
Finally, the Court rejected Hexion’s focus on the underperformance of two of Huntsman’s divisions. Hexion’s burden was to establish that a MAE had occurred on Huntsman as a whole (which the Court rejected in the first line of argument) and the two divisions were expected to generate only 25% of Huntsman’s adjusted EBITDA in 2008. Moreover, the Court noted that the downturn in the two divisions appeared to be short-tem in nature.
In terms of Huntsman’s claim that Hexion knowingly and intentionally breached its covenants, the Court found several examples. Most notably, by pursuing a strategy of establishing that the combined entity would be insolvent in order to prevent debt financing from being available (including commencing litigation in Delaware and circulating copies of the complaint to its financing sources), Hexion breached the negative covenant in the agreement not to take any action that could reasonably be expected to materially impair, delay or prevent consummation of the financing contemplated by the debt commitment letter.5 The Court noted that at trial Hexion’s chief executive officer agreed that publication of the solvency opinion and the filing of the lawsuit “effectively kill[ed] the financing” and made it “virtually impossible for [the lending banks] to go forward with the financing.”
The Court granted Huntsman’s request for an order specifically enforcing Hexion’s contractual obligations to the extent permitted by the agreement, but did not order Hexion to consummate the merger. The Court noted that a provision in the merger agreement expressly precluded Huntsman from obtaining specific performance to cause Hexion to consummate the merger. Huntsman’s argument that it had such right under the merger agreement was contradicted by its own proxy statement disclosure and was rejected by the Court.6
The Court did not rule on whether the combined entity would be insolvent at closing and criticized Hexion for failing to explore options for mitigating the risk of insolvency and not performing its contractual obligations in good faith. Vice Chancellor Lamb stated that “[i]f, at closing, and despite the buyer’s best efforts, financing had not been available, the buyer could then have stood on its contract rights and faced no more than the contractually stipulated damages. The buyer and its parent, however, chose a different course.” According to the Vice Chancellor, “it appears that after May 9, 2008 Apollo and its counsel began to follow a carefully designed plan to obtain an insolvency opinion, publish that opinion (which it knew or reasonably should have known, would frustrate the financing), and claim Hexion did not ‘knowingly and intentionally’ breach its contractual obligations to close due to the impossibility of obtaining financing without a solvency certificate.” According to the Court, Apollo and Hexion attempted to use the purported insolvency of the combined entity as an “escape hatch” to Hexion’s obligations under the merger agreement.
There are several key takeaways from the Court’s decision:
- The buyer has the burden of establishing a MAE and no buyer has successfully done so in a Delaware court. The Court followed the IBP v. Tyson (Del. Ch. June 15, 2001) decision (even though that case involved a merger agreement governed by New York law) which held that proving that a MAE has occurred is difficult and that the burden is on the party that is seeking to excuse its non-performance on those grounds. This is the case regardless of whether the material adverse effect provision is drafted as a representation, covenant or condition. Historically, the invocation of a MAE provision to avoid closing an acquisition has been met with hostility by Delaware courts, and the Hexion decision indicates that judicial animus to such provisions has not changed. Vice Chancellor Lamb noted this in his opinion, stating that “[m]any 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.”
- Buyers need to avoid taking actions that may be construed as intentionally trying to undermine the financing. The managing director of Hexion’s financing source testified that, until the filing of the lawsuit by Hexion, the bank had not questioned the solvency of the combined company or whether a MAE had occurred. Following publication of the insolvency opinion, Hexion’s financing source began to study the potential insolvency of the company. A buyer standing on its own to declare a MAE is at risk, particularly if its actions then become responsible for the impossibility of financing.
- Given the high hurdles that must be overcome to establish that a MAE has occurred and the failure of past buyers to overcome such hurdles, buyers need to consider demanding tailored closing conditions for protection. When negotiating an acquisition agreement, buyers need to take into account the difficulty of establishing the occurrence of a MAE. If a buyer has the negotiating leverage to obtain a closing condition that addresses a specific risk that they otherwise would have relied upon a MAE provision for protection (e.g., the risk that the target fails to generate sufficient EBITDA7 between signing and closing), the buyer should push for such a condition now more than ever.8 (We have seen private equity buyers obtain EBITDA-based closing conditions in several public company transactions this year.)
- Only an adverse effect to the long-term earning potential of a target will constitute a MAE. To constitute a material adverse effect, poor earnings results must be expected to persist significantly into the future. According to the Court in Hexion, “[t]he important consideration therefore is whether 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 phrase “financial condition, business or results of operations” in a MAE definition will be interpreted consistent with Regulation S-X and Item 303 of Regulation S-K (Management’s Discussion and Analysis of the Financial Condition and Results of Operation). The proper benchmark for analyzing a change in “financial condition, business or results of operation” with respect to a material adverse effect claim is to examine each year and quarter end and compare it to the prior year’s equivalent period.
- The target company as a whole must have suffered a MAE. A MAE is determined based on adverse changes to the target company’s business as a whole; specific business units of a company may not be viewed in isolation to establish that a MAE has occurred.
- Carve-outs are secondary to the MAE analysis. A court will only consider the carve-outs to a MAE clause if it has first been established that a MAE has occurred.
- In cash acquisitions, EBITDA is an important test for whether a MAE has occurred with respect to operations. EBITDA is the appropriate measure for determining whether a MAE has occurred with respect to the business operations of a company in the context of a cash acquisition.
- Disclaimers are relevant to the determination of a MAE, even if in a separate provision in the agreement. Absent express language in an agreement to the contrary, a disclaimer that the target company makes no representations or warranties as to its projections will be relied upon by a Delaware court to exclude failure to meet projections as a basis for establishing that a MAE has occurred.
- Extrinsic evidence (i.e., facts or information not embodied in the contract at dispute) can play an important role in the court’s determination. If a deal provision is ambiguous, a court is going to look at extrinsic evidence, such as the target company’s proxy statement disclosure or the buyer’s financial models, to help ascertain the intent of the parties. For target companies, this means that they need to carefully draft their proxy statement disclosure given that it may be read by a court to ascertain their intent about an important deal provision. For buyers, this means that they need to be actively involved in the drafting process of the target’s proxy statement to make sure that it doesn’t include an interpretation that is contrary to the buyer’s. Buyers will also want to push target companies to draft their proxy statement concurrently with the negotiation of the merger agreement so that it is filed as soon as possible after execution of the merger agreement and minimize the risk of self-serving drafting. Buyers also need to recognize that it is going to hurt their ability to claim that a MAE has occurred due to a downturn in the target’s recent or projected financial performance if any of the buyer’s financial models used to justify the deal price had assumed such downturn.
To establish a “knowing and intentional breach,” a party doesn’t need to show that the other party intended to breach. A “knowing and intentional breach” is the taking of a deliberate act, which act, in and of itself, constitutes a breach of the merger agreement. It does not require establishing that the party committing the act consciously intended to breach the agreement. In other words, if a seller can show that the buyer acted intentionally, the buyer may not argue as a defense that it didn’t intend the consequences of its action.