Introduction — Curtains on an Era

For a number of years leading up to early 2007, we saw record growth in mergers and acquisitions activity both in North America and beyond. This was fuelled in part by the availability of cheap credit and the proliferation of large private equity buyout investors, which spawned myriad multi-billion dollar transactions, in some cases the largest in history. In 2005, M&A transaction volume exceeded US$65 billion dollars in Canada and US$885 billion in the United States. In the US alone, this represented a 58% increase over M&A volumes in 2002. North American deal volumes broke another record in 2006. In just the first six months of 2007, M&A activity again hit a record high, with almost US$754 billion and US$62.6 billion in deal volume for each of United States and Canada.1

And then, almost overnight, everything changed.

For private equity and other M&A transactions dependent on significant leverage, the credit crisis commenced in late June 2007. At this stage, there were more than 100 announced private equity transactions in North America of larger than $1 billion that were at various stages in the process of being closed. Most of these transactions were predicated on arranging significant amounts of debt, often broken into complex structures with tranches of senior and subordinated debt. In most cases, lenders had issued commitment letters, anticipating little trouble syndicating much of this in the form of collateralized debt obligations. As the credit crunch set in and challenging economic conditions spread to various sectors in the economy, many of these transactions became unsustainable on the terms at which they were initially struck. This was further exacerbated by the precipitous decline in equity markets in 2008.

Toward the end of 2007 and throughout 2008, almost all of the pending transactions were either renegotiated or terminated altogether. The proposed $52-billon purchase of BCE Inc. by Ontario Teachers’ Pension Plan Board and its US private equity consortium partners, the largest announced buyout in history and one of the last of these deals to be announced was, perhaps fittingly, the last one to expire, terminating on December 11, 2008. The chart below outlines the fate of a number of these transactions.

Please click here to view table.

This rising crescendo of M&A activity, and the subsequent turmoil surrounding pending deals caught up in the credit crisis, gave rise to a number of high-profile disputes. The resulting litigation in many cases prompted courts to scrutinize the terms of these transactions and address the actions of boards of directors and management of many of the target companies. Courts were also asked to address the actions of lenders and advisors to both target and purchaser parties. With these court decisions came a number of important legal developments. The impact will be reflected in future M&A transactions — first, as the credit crunch continues, and then as the economy eventually emerges from these challenging economic times, and, in all likelihood, a new wave of deal activity commences.

This article examines a selection of recent court decisions in Canada and the United States arising out of this period of frenzied deal-making and the subsequent broken deals that resulted in many instances. Broadly speaking, this article focuses on two areas: (i) the duties of boards of directors and the actions of target companies in the face of a pending M&A transaction; and (ii) how courts have interpreted select deal terms and the interplay of some of these terms. Through this examination, I attempt to provide some practical thoughts on what lessons can be learned through these failed transactions.

Duties of Boards and Actions of Target Companies

Examination of the sales process has long provided fertile ground for those who wish to challenge a business combination. There are many cases stemming from allegations that boards of directors and management of a target company acted inappropriately in the context of the sale of the company. The plaintiff is often a group of disgruntled shareholders unhappy with the price paid, but the challenge may also come from other company stakeholders or from another bidder snubbed in the end for the successful suitor.

These challenges have, over time, established a considerable wealth of jurisprudence that, together with applicable corporate and securities regulatory requirements, informs the role of directors and management and the actions of target companies in the face of a proposed sale transaction. The recent wave of M&A activity and subsequent deal turmoil has resulted in some interesting developments. These will serve as reminders to boards of directors and management of their duties in general and in particular in the context of a proposed sale of a company.

BCE Inc.

The proposed buyout of BCE Inc. by Teachers’ and its consortium partners was struck at the end of June 2007, right as the first hints of the credit crisis were being felt. The transaction was structured as a plan of arrangement under the Canada Business Corporation Act (CBCA) and was approved by the Québec Superior Court in March 2008. In an unexpected decision, the Québec Court of Appeal overturned the trial judge’s approval of the plan of arrangement in May 2008. After agreeing to an accelerated timetable, the Supreme Court of Canada heard an appeal in June 2008 and reinstated the trial judgement. Had the Court of Appeal judgement been upheld, it would have represented a significant departure from accepted corporate law in Canada and likely would have had far-reaching implications for future M&A transactions in Canada. It was not until December 19, 2008, shortly after the BCE transaction had terminated,2 that the Supreme Court of Canada released reasons for its decision.3

The litigation arose out of a challenge by certain debentureholders in Bell Canada, the principal subsidiary of BCE. The transaction structure, agreed to by BCE and the Teachers’ consortium following an active auction of the company, required Bell Canada to provide a guarantee of approximately $30 billion in debt to be incurred as part of the buyout transaction. The transaction had been structured in a manner that did not require approval of the debentureholders. However, it was acknowledged that the resulting additional debt would have meant the decline of the short-term trading value of the debentures by an average of 20%, and the debentures could have lost their investment grade status. The debentureholders challenged the actions of the directors in approving the plan of arrangement. They argued the transaction was oppressive to the reasonable expectations of the debentureholders as stakeholders in the company and the transaction failed to meet the "fair and reasonable" test required for the court to approve a plan of arrangement under the CBCA.

Fiduciary Duties of Directors

The court provides a detailed discussion of the fiduciary duties of directors. It provides some additional clarity as to those duties where the interests of the corporation and its stakeholders are in conflict. This is particularly relevant in the context of an M&A transaction.

Drawing from its decision in Peoples Department Stores Inc. (Trustee of) v. Wise4 the court notes that "It is the duty of directors to act in the best interests of the corporation. Often the interests of shareholders and stakeholders are co-existent with the interests of the corporation. But if they conflict, the directors’ duty is clear — it is to the corporation." In considering what is in the best interest of the corporation, directors may, but are not required to, look at the interest of inter alia, shareholders, employers/employees, creditors, consumers, governments and the environment to inform their decision. Applying this to the facts, the court notes:

Directors, acting in the best interests of the corporation, may be obliged to consider the impact of their decisions on corporate stakeholders, such as the debentureholders in these appeals. This is what we mean when we speak of a director being required to act in the best interests of the corporation viewed as a good corporate citizen. However, the directors owe a fiduciary duty to the corporation, and only to the corporation. People sometimes speak in terms of directors owing a duty to both the corporation and to stakeholders. Usually this is harmless, since the reasonable expectations of the stakeholder in a particular outcome often coincides with what is in the best interests of the corporation. However, cases (such as these appeals) may arise where these interests do not coincide. In such cases, it is important to be clear that the directors owe their duty to the corporation, not to stakeholders, and that the reasonable expectation of stakeholders is simply that the directors act in the best interests of the corporation.

Scope of Fiduciary Duties

The court also confirms that the fiduciary duty of directors is a broad, contextual concept. It is not confined to short-term profit or share value, and, where the corporation is an ongoing concern, directors must look to the long-term interests of the corporation.

This is distinct from the duty of directors under Delaware law, based on the line of cases flowing from the Revlon5 decision where, faced with a sale process, the board is required to focus its attention on the interests of the shareholders and sell it to the highest bidder. The Supreme Court does not expressly reject the Revlon doctrine but does state clearly that the law in Canada requires a broader focus even in the context of the change of control. It rejects the idea that directors should prioritize the interests of one group over another. Provided the board is properly informed and follows a fair process in which relevant interests are considered, a court shall defer to a board’s reasonable conclusions and be reluctant to interfere in those conclusions.

Importance of the Business Judgement Rule

Courts are reluctant to review board decisions even if it is wrong, provided the directors were acting in good faith and in the best interests of the corporation. The rule evolved to some extent out of necessity with the courts lacking resources to second guess board decisions. In C.W. Shareholdings Inc. v. WIC Western International Communications Ltd.6 the court summarized the business judgement rule as follows:

Where business decisions have been made honestly, prudently in good faith and on reasonable and rational grounds, the courts will be reluctant to interfere and to usurp the board of directors function in managing the corporation. In such cases, the board’s decision will not be subject to microscopic examination.

The court in the BCE decision applied the business judgement rule in the context of the conflicting interests of stakeholders noting that courts should give appropriate deference to the business judgement of directors who take into account these ancillary interests. The business judgement rule accords deference to a business decision so long as it lies within a range of reasonable alternatives.

Oppression Remedy Claim

The Supreme Court concludes that the trial judgment was correct when it held that when faced with conflicting interests, directors might have no choice but to approve a transaction that, while in the best interests of the corporation, will benefit some groups at the expense of others. It viewed positively the process the board of directors of BCE had created that had resulted in a competitive bidding process in response to actions by Teachers’ to put BCE "in play." This process had brought forth three bids at substantial premiums to the market trading price. All were leveraged bids and there was nothing realistically that BCE could do to avoid the risk to debentureholders.

The court went on to conclude that while the debentureholders had a reasonable expectation that the board would consider its interests, leveraged buyouts are not unreasonable or unforeseen and based on the evidence, the court concluded that a board had fulfilled its obligations in this regard. On that basis, the oppression claim failed.

Plan of Arrangement Considerations

Having dealt with the oppression claim, the court then focussed on the second argument of the debentureholders — that the trial judge should have not approved the plan of arrangement on the basis that it was not fair to the debentureholders.

The court clearly distinguished the oppression remedy from that of a court approval required in a plan of arrangement. It noted that the oppression remedy is a broad equitable remedy that focuses on the reasonable expectations of stakeholders. In contrast, in a plan of arrangement, the court is principally concerned with the legal rights of those parties whose interests are being arranged. In assessing whether a plan of arrangement is "fair and reasonable" the court determines that it must be satisfied that: (i) the arrangement has a valid business purpose; and (ii) the objectives of those whose legal rights are being arranged are being resolved in a fair and balanced way.

In assessing this, the court may take into account various factors, including a vote by security holders, the proportionality of the impact on affected groups and whether or not a reasonable process is followed by the corporation. The court may also consider the repute of the directors and advisors who endorse the arrangement and the arrangement’s terms. It may also take into account whether or not it’s approved by a special committee of independent directors, the presence of a fairness opinion from a reputable expert and the access of shareholders to dissent and appraisal remedies.

The court draws a distinction between the "legal rights" of the debentureholders and their "economic interests." Except in exceptional circumstances, those rights are limited to legal rights and not economic interests. Having concluded that the arrangement did not affect the debentureholders’ legal rights, their economic interests did not merit consideration in these circumstances. In concluding the matter the court noted that "… there is no such thing as a perfect arrangement. What is required is a reasonable decision in light of the specific circumstances of each case, not a perfect decision." The court agreed with the trial judges finding that that the arrangement dealt with the legal rights of the debentureholders in a fair and balanced way.

Ryan v. Lyondell Chemical Company

The decision of the Delaware Chancery Court in Ryan v. Lyondell Chemical Company7 is one of the most recent and, in some circles, one of the more criticized judgements to consider the actions of directors in the context of an M&A transaction. The decision, in many respects, in the actions of the directors of Lyondell, stands in contrast to the BCE decision discussed above.

The facts involved the US$13B acquisition of Lyondell Chemical Company by Basell AF struck in July 2007. The transaction had been overwhelmingly approved by stockholders. The price paid in cash represented a 45% premium over Lyondell’s trading price prior to public knowledge of Basell’s interest and a 20% premium over the stock price at the time the merger agreement was announced. The deal closed but a class action law suit challenging the actions of the Lyondell directors in connection with the transaction survived completion.

The July 29, 2008 decision arose out of a motion for summary judgment by the defendant Lyondell directors. The court refused to grant summary judgment in favour of the directors and found that there was a question of fact as to whether or not the directors had breached not only their duty of care but also their duty to act in good faith by agreeing to the Basell take-over.8

As noted above, in the United States, boards of directors have a duty under the Revlon doctrine in the context of a sale of the company to have a singular focus on seeking the highest value reasonably available to stockholders. Based on a number of factors, the court in Lyondell concluded it could draw a reasonable inference that the directors had violated their Revlon duties:

  • The deal was negotiated, considered and agreed to in less than seven days and the board met for no more than seven hours in three meetings over that time to consider the Basell proposal — raising questions as to how much the board had really considered the transaction and whether it addressed all alternatives available.
  • After Basell made its filing with the SEC disclosing it acquired a right to purchase up to 8.3% of Lyondell’s stock from its second largest shareholder, the board took no action. In the circumstances it might reasonably have engaged an investment banker, required management to prepare projections or assess Lyondell’s value, and conduct some form of formal market check in anticipation of a receiving a proposal from Basell.
  • The board did not actually negotiate with Basell or actively participate in the sale process. The court drew attention to the fact that the Chief Executive Officer of Lyondell conducted the negotiation process without the knowledge of the board, thereby questioning whether the process was done on an independent basis. The court however notes that the directors themselves did appear to be independent.

The board did not conduct even a limited market check to determine interest in the company or parts of it as a means of assessing the strength of the Basell proposal. The court noted the lack of a preannouncement market check and the lack of a go-shop provision. The court acknowledged that Revlon does not demand a perfect process and the board has considerable latitude in structuring the sale process provided it acts diligently in pursuit of the best transaction reasonably available. The court noted however that "the Board did nothing (or virtually nothing) to confirm the superiority of the price but, nonetheless, it provided Basell with a full complement of deal protections." Despite the substantial premium paid by Basell and other compelling facts the court noted that stockholders may not have received the best price available.

As noted, many commentators have been critical of this decision. It is under appeal but if it does stand, perhaps one way to view this decision is on the basis that it was only the result of a motion for summary judgment and turned on whether or not there was a question of fact that the Lyondell directors had breached their duty of good faith.

Re AiT Advanced Information Technologies Corporation

Although not focused on the fiduciary duties of directors, the recent decision of the Ontario Securities Commission ("OSC") in Re AiT Advanced Information Technologies Corporation does provide some clarification and guidance to boards of directors of public companies in Canada with regard to when disclosure obligations are triggered in a sale process. It also further highlights the importance of establishing appropriate governance procedures when a board of directors is faced with a possible sale of the company.

The OSC staff had alleged AiT and its directors and officers had breached applicable provisions of the Securities Act (Ontario) in failing to disclose AiT’s agreement with 3M Company until a definitive agreement was signed. Applicable Canadian securities laws require reporting issuers to promptly disclose all material changes. If the issuer is negotiating to sell the company this is likely a material fact that will restrict insiders from trading in the issuer’s shares, but the obligation to disclose does not arise until the material change occurs.

In its decision the OSC noted that there is no bright line test as to when the material change occurs. Depending on the fact in a given set of merger negotiations and the nature of a letter of intent the parties may have entered into, a material change and thereby a disclosure obligation may arise in advance of the parties signing a definitive agreement. The OSC notes that:

a decision by a board of directors of an issuer to pursue a transaction that is not yet within its control to put into effect (and therefore is not capable of achievement) would not ordinarily be a material change in the business, operations or capital of an issuer at that point in time unless the board has reason to believe that the other party is also committed to completing the transaction.

Further, while the business judgment rule does not protect disclosure decisions under applicable securities laws, such as when a material change arises, the OSC did recognize that if a board of directors has an effective governance process in making disclosure decisions it will be difficult for the OSC to question a judgement reached as a part of such a process.

Other Recent Delaware Decisions

The Delaware Chancery Court also issued three significant decisions in 2007 addressing the fiduciary duties of directors in the context of an anticipated M&A transaction. Each of In re Netsmart Technologies, Inc. Shareholder Litigation,9 In re Topps Co. Shareholders Litigation10 and In re Lear Corp. Shareholder Litigation11 pre-date the start of the credit crisis. In each case, the deal in question came about during the period of record M&A activity and stakeholders in each instance challenged the actions of the board of directors in relation to the transaction.

Netsmart Technologies

The board of directors had approved a transaction by two private equity sponsors to acquire Netsmart in November 2006. This decision arose out of a preliminary injunction by stockholders to block the transaction from proceeding. The board of Netsmart had authorized an auction process to consider proposals from private equity bidders and had expressly determined not to seek offers from strategic bidders. In its decision the court concluded that there was a reasonable probability of success on the merits that the directors breached their fiduciary duties in deciding to only pursue private equity bidders.

The court noted that informal and sporadic contact with potential strategic buyers was insufficient to conclude they would not subsequently be interested in Netsmart at the time of auction. Further, the relatively light deal protection terms in the merger agreement — which included a window shop to allow the board to entertain unsolicited bids and 3% break fee — did not cure this oversight. The court noted that Netsmart was unlikely to get interest from strategic buyers following announcement of the deal on the basis, among others, that Netsmart as a "micro cap" company and that management would have been perceived as preferring a private equity buyer.

The court also expressed scepticism regarding the process established by the board. It noted that management would have the prospect of continuing employment and an equity interest in the company going forward. Despite the potential conflict of interest management played a leading role — negotiating with the private equity buyers, conducting due diligence and engaging financial advisors. The board was late in establishing a special committee and once established it did not play an active role — neither the special committee nor its financial advisors were involved in discussions between the potential private equity buyers and management. The court commented that the special committee "conducted itself in a manner that invites stockholder suspicion." The court did grant an injunction but not a broad one blocking the merger altogether. Instead Netsmart was only required to supplement its disclosure.

This decision is really a product of the time period in which the facts arose. It is unlikely in the current deal environment that a board, in the context of tight credit markets where private equity sponsors no longer have a perceived advantage, would be inclined to expressly exclude strategic investors. In any case, Netsmart provides a reminder to boards to be wary of proposals to exclude one or more classes of bidders from a sale process without reasonable justification.

The Topps Company

This decision involved challenges to the proposed acquisition of The Topps Company, Inc. at US$9.75 per share by private equity sponsors including Michael Eisner and Madison Dearborn Partners. At the insistence of Eisner group no formal auction had been conducted by Topps prior to the announcement of the proposed deal on March 6, 2007. Instead, the private equity group had entered into a merger agreement which contained a go shop provision and a bifurcated break fee (3.0% of the transaction value during the go shop period and 4.6% of that amount after the go shop period). The agreement also included a right to match in favour of the private equity buyers.

During the go shop period (40 days from signing of the merge agreement) Topps’ investment bankers solicited more than 100 bidders but The Upper Deck Company — the principal competitor of Topps — was the only serious bidder to emerge. At the end of the go shop period, after some degree of negotiations, the board rejected Upper Deck’s then most recent expression of interest at US$10.75 per share, citing it was not likely to lead to a "superior proposal" as contemplated in the merger agreement on the basis of financing and anti-trust risks. The go shop period ended. After which Upper Deck made another unsolicited offer at the same price but the Topps board still concluded it would not a superior proposal and refused to release Upper Deck from its standstill agreement.

Litigation ensued with both the Topps and Upper Deck stockholders challenging the actions of the Topps board. The plaintiffs were unsuccessful in their challenge that the deal protection measures were inappropriate. The court appears to endorse the go shop provision. It notes the board did not conduct a pre-signing market check and acknowledges the go shop coupled with a reduced break fee "left reasonable room for a post-signing market check." As well, the court was not troubled by the right to match granted to the private equity buyers. The actions of some of the directors during the course of the go shop period did draw criticism from the court — the facts suggesting these directors openly favoured the Eisner bid.

In the end however, the failure of the Topps board to release Upper Deck from its standstill commitment was the basis for the courts grant of a preliminary injunction. The court held the directors breached their fiduciary duties by ceasing to continue negotiations after the go shop period ended and by refusing to release Upper Deck from its standstill commitment. The injunction forestalled Topps from completing the merger until Topps made supplemental disclosure and waived the standstill to allow Upper Deck to conduct a cash tender.

Lear Corp.

This final Delaware decision relates to the attempted acquisition of Lear Corp. in a leveraged buyout led by Carl Icahn. Stockholders sought to enjoin Lear from proceeding with the transaction on a number of grounds. In granting a preliminary injunction in favour of the plaintiffs delaying the stockholder vote on the merger, the court is again critical of certain actions of the Lear board of directors.

In January 2007, Icahn, then a significant stockholder of Lear, proposed to take Lear private and planned to retain the management team following completion. Icahn had discussed this for some time with the chief executive officer of Lear before informing the rest of the board. The board subsequently struck a special committee to negotiate terms with Icahn and consider alternatives. The committee then authorized the CEO to take the lead in running the due diligence process and negotiate terms with Icahn. The committee considered, but chose not to, conduct a formal auction, in part as Icahn threatened to back out, but also due to concerns about public disclosure that might be harmful to Lear. Icahn and the company did however agree to a 45 day go shop period following announcement of the merger with a bifurcated break fee (2.75% of equity value of the deal during the go shop period and 3.52% after) and a right for Icahn to match.

The court expressed concern with actions of the board and management stating that the actions of the CEO and the lack of direct involvement by the special committee unnecessarily raised "concerns about the integrity and skill of those trying to represent Lear’s public investors." The court stopped short of saying the CEO acted inappropriately but did require additional disclosure regarding the conflict of interest and related details in Lear’s proxy statement.

The court however rejected the stockholder claim challenging the validity of the go shop provision and the deal protection terms. The decision provides further assistance with regard to the use of go shop provisions and the context in which they can be combined with deal protection provisions.

Some Take Away Thoughts for Boards of Directors

What can be learned from some of these decisions? What can boards of directors do to avoid missteps outlined in some of these decisions? These decisions will likely further inform some well-established best practices, many of which were the focus of earlier disputes:

  • Role of the Board of Directors — The directors are ultimately responsible to act in the best interest of the corporation. This will involve directing and overseeing any sale process. They should play an active role in structuring the process and supervising management and any advisors.
  • Establish a Process with a Critical Eye — The directors should carefully consider whether a particular process has been designed and carried out and any subsequent sale transaction is structured so that under the particular circumstance, the board has considered the impact of the decision on relevant stakeholders in the corporation as part of its role in reaching a decision that is in the best interest of the corporation.
  • Strategic Reviews — The board of directors should be reviewing the corporation’s strategy on a periodic basis. This should include its position in the industry and an assessment of its readiness to deal with unsolicited offers. Boards will then be better prepared to react decisively to developments and be prepared to consider in advance fiduciary responsibilities in the context of a sale and related process.
  • Take a Proactive Stance — When an early warning report does come to light or an unsolicited offer is brought forward, a proactive response by the board and its direct involvement may help to avoid a situation of the type that arose in Lyondell and Lear Corp. Boards should act early and take advantage of the time available to them and make adequate preparations.
  • Consider Impact of Decisions on All Corporate Stakeholders — Directors owe a fiduciary duty to the corporation, and only to the corporation. In considering what is in the best interest of the corporation, directors may, but are not required to, look at the interest of inter alia, shareholders, employers/employees, creditors, consumers, governments in the environment to inform their decision. Any sale process established should provide an opportunity to consider the interests of these constituent groups.
  • Scope and Role of Management — Management’s involvement is generally important to an effective sale process. Senior management should not conduct critical negotiations before involvement of the board or without effective oversight and instruction from directors.
  • Address Inherent Conflicts Facing Management — A board should be cognizant of inherent conflicts that may arise given management’s interest in ongoing employment and potential equity interest in the company going forward. Courts frown upon a process that allows officers to negotiate material, financial and structuring terms of a transaction and conduct due diligence exercises without effective input from the board. Conflicts may be particularly pronounced in a private equity structure where management may hold a substantial equity interest in the structure going forward.
  • Allow Adequate Time — Adequate timing should be allotted to scheduling board meetings for consideration of proposals in a sale process. In Lyondell, for example, the court questioned whether the board could have fully and effectively considered all matters in the course of only three relatively short meetings.
  • Single Bidder Strategy — A single bidder strategy requires particular care and preparation. Where a board has reliable evidence to evaluate the fairness of a sale transaction in relation to potential alternative transactions, it may approve a sale without conducting a formal auction or a canvas the market. The board should weigh the costs and benefits of such an approach and consider the sufficiency and reliability of information available to it.
  • Deal Protection Terms — The directors and advisors should not assume that deal protection terms can be treated as "boilerplate." An acceptance of "market norms" for break fees and other terms without also considering the context and the impact can be dangerous. The appropriate package of deal protection terms require a careful review of the applicable facts.
  • Documentation — The board should ensure a well-documented contemporaneous record of careful board deliberations is in place. This should include periods leading up to and throughout the sale process. In many of the cases noted, challenges by interested parties focus on perceived inadequacies of board action (or inaction). A record of deliberations is often key evidence in refuting such claims. Minutes should be in sufficient detail so as to later allow directors to accurately recall the scope and substance of deliberations and the information and any advice that directors relied upon. Ideally, minutes should also note the approximate length of time spent considering matters of importance.
  • Guidelines for Action — The board should set clear guidelines for action by board members, committees and members of management in addressing applicable aspects of and responses to possible developments related to a sale process.
  • Appropriate Market Checks — Board should be carefully considering what pre-market checks and post-signing mechanisms for market checks — such as a go-shop provision — should be required during the negotiation process and determination of agreed upon market checks should be documented accordingly.
  • Canvassing the Whole Market — Boards should not presuppose that one class of bidder or one group of bidders is not interested in the company — as the board has concluded in respect of strategic investors in Netsmart. The board should also not assume that potential bidders will find the company. Again, the court was critical of the board’s action and Netsmart given its status as a "microcap" in the United States — the size of company that is far more common in Canada. In that light, boards of Canadian companies should be particularly careful in ensuring an adequate process is established to reasonably canvas all potential candidates.
  • Reliance on Financial Advisors — There are limits to a board’s ability to be able to reasonably rely upon financial advisors. As noted in Lyondell, a fairness opinion only speaks to the fairness of the transaction, a financial point of view. A fairness opinion does not speak to whether the proposal is the best transaction available to the company. Delivery of a fairness opinion is no substitute for an appropriate market check.
  • Standstill Agreements — Confidentiality and standstill agreements play an important role in helping boards manage an M&A process. However, boards should be cognizant of their fiduciary duties to the corporation once the process has resulted in an initial definitive agreement with a bidder. At that stage, it may be in the best interest of the corporation to waive standstill restrictions on other bidders. Before doing so, boards should be careful to ensure compliance with contractual commitments — a definitive agreement may limit the ability of the company to waive a standstill agreement.12

Both the Canadian and US decisions are consistent that there is no specific required process to be followed by the board and the board is not required to make a "perfect" decision. The courts will defer to the reasonable business judgement of the board provided the board has taken adequate and appropriate steps along those that are outlined above.

Deal Terms Under the Microscope

As the credit crisis took hold in the second half of 2007, it became increasingly challenging to complete the pending M&A transactions on the terms as they were initially struck. In many cases, private equity sponsors and their lenders naturally turned to the definitive agreements, commitment letters, supporting guarantees and other relevant documents they had entered into a short time earlier — but this time one supposes — in new light. Was there an opportunity to renegotiate? On what basis could the deal be terminated? What liability were they exposed to — could it be limited or eliminated? What was the appropriate course of action?

These transactions in many cases were entered into in the frenzy of a competitive auction where multiple bidders competed by offering a higher price and more favourable terms — fewer closing conditions more lenient representations and warranties. The architecture of many of the transaction agreements had been borrowed from earlier deals, and in more than a few cases, probably without the degree of care and forethought for which some practitioners, working under more ideal conditions, would have hoped.

As private equity sponsors and lenders sought ways out, disputes arose.13 Parties engaged in high stakes battles over conflicting contract interpretations. In some cases courts were called upon to arbitrate and many of the complexities, ambiguities, inconsistencies and overlooked provisions in the transaction agreements became a focal point. With these court decisions came a number of important legal developments.

Material Adverse Change

With perhaps the first sign of trouble, some private equity sponsors began utilizing material adverse change (MAC) clauses to terminate acquisition agreements in early fall of 2007.14 Generally, a MAC clause provides the purchaser in an acquisition agreement with an opportunity to not complete the acquisition in the event some material and adverse change occurs in respect of some aspect of the target company prior to the completion of the acquisition. The terms of a MAC clause, as well as a broad range of carve-outs from the MAC, are often a key focus at the time the agreement is negotiated. While there are no significant Canadian cases that interpret a MAC clause in the context of an M&A transaction, there are a number of recent US decisions that provide some useful guidance.

Hexion Specialty Chemicals, Inc. v. Huntsman Corp.

Recent litigation surrounding the proposed acquisition of Huntsman by Hexion Specialty Chemicals15 provides another cautionary tale. In this case, Huntsman, a global chemical company, commenced an M&A process to sell itself in early 2007. It entered into a merger agreement with Basell AF16 in June 2007. Shortly after that, Hexion, a portfolio company of the private equity firm, Apollo Global Management, entered into a $10.6-billion deal back in July, 2007, topping the Basell offer. The credit crisis set in shortly after announcement of the deal and Huntsman’s results began to decline as well.

Then, in June 2008, Hexion applied to Delaware courts for a declaratory judgment that (i) Hexion was not obligated to close the transaction if the combined entity would be insolvent — which would have made financing impossible to obtain, and (ii) Huntsman had suffered a material adverse effect (MAE).17 Prior to seeking the declaratory judgment and without notifying Huntsman, Hexion had obtained an insolvency opinion from a valuation expert and had spent considerable time assisting the expert in support of its analysis. With a declaration that the combined entity would be insolvent, Hexion could terminate the merger agreement and its liability would be limited to its US$325 million reverse termination fee — as there would be a failure to obtain financing. If a declaration had been obtained to the effect that Huntsman had suffered an MAE, Hexion would have been relieved from all liability under the merger agreement. Hexion was — somewhat spectacularly — unsuccessful.

The court looked to the earlier decisions in In re IBP, Inc. Shareholders Litigation18 and Frontier Oil Corp. v. Holly Corp.19 to assess whether Huntsman had not suffered an MAE. Followed the test set down in those decisions, an MAE results only when "unknown events ….substantially threaten the overall earnings potential of the target in a durationally-significant manner." In applying the MAE test to the facts at hand, the court makes some interesting findings.

It confirmed that absent clear drafting to the contrary, the burden of proof for determining the existence of an MAE is on the party asserting it, in this case Hexion. It also determined that the analysis first requires a determination of whether an MAE has occurred before the court will then consider the applicability of one of the myriad carve-outs to an MAE typically found in merger agreements. So, Hexion’s claim that the Huntsman financial results were disproportionally worse than those generally in the chemical industry (as contemplated in one of the carve-outs to the MAE provision) did not come into play if Hexion could not first show an MAE in the first place.

Further, a proper analysis of an MAE is on a year-over-year comparison of the "financial condition, business or results of operation" of the target. Courts will not look to short-term "blips" in assessing whether a MAE has occurred. The court found that an analysis of the future performance of the target is still relevant to the MAE analysis as a measure to be compared to historical performance. However, in this case, looking to the representations and warranties, the court noted Hexion could not assert the company’s failure to meet projections because reliance upon projections had been disavowed pursuant to the terms of the merger agreement.

The court notes Hexion’s assertion of earnings per share as the proper benchmark for measurement of an MAE is problematic in the event of a cash deal. "Earnings per share" is, for the most part, a function of the capital structure of the company reflecting the effect of leverage. In recognizing that cash buyers often reshape the capital structure of an acquired entity, the court felt that pre-merger earnings per share were largely irrelevant in that context and that what matters are the results of operations of the business, namely those measured by EBITDA. Huntsman’s EBITDA had not deteriorated over the relevant period to a degree that would reasonably amount to an MAE.

In a reminder of just how high the bar is in proving an MAE, the court in Hexion at one point refers to commentary that no Delaware court has ever found an MAE in the context of a merger.

Genesco and Finish Line

A similar dispute arose earlier in 2007 in respect of the MAC clause in the merger agreement between Finish Line, Inc. and Genesco, Inc.20 In June 2007 the two footwear retailers entered into a US$1.5-billion highly leveraged transaction that would have seen the much smaller Finish Line, with substantial financing support from UBS, acquire the much larger Genesco. Less than three months later things started to go bad. Genesco released quarterly earnings statements well short of projections. Finish Line and UBS refused to proceed to closing.

Genesco brought a claim in Tennessee to compel completion of the acquisition. Genesco disputed Finish Line’s argument that the earning shortfall constituted a material adverse change on the basis that it represented a short-term decline due to general economic conditions that fell within the carve-outs of a MAC claim in the agreement. The court held that the agreement contained a carve-out for general economic conditions, and the MAC claim was therefore rejected.

The court did, however, go on to analyze the MAC clause and acknowledge that, as drafted in the merger agreement, the parties had put their minds to the possibility of a MAC occurring in as little as three or four months.

Other Recent Disputes Involving MAC Clauses

Despite the outcome in both Hexion and Genesco, a number of recent disputes involving private equity deals demonstrate the potential power that the MAC clause can provide for buyers seeking to terminate or renegotiate the terms of a merger when the target company’s business deteriorates in advance of closing. Examples can be found in disputes involving each of J.C. Flowers & Co. and Sallie Mae, KKR and Harmon International, Home Depot and Clear Channel, to name but a few. In each case, there is no court decision to point to that interprets the applicable MAC provision. However, in each case the transaction was either renegotiated or terminated in part due to the buyer’s assertion that a MAC existed.

Given the relatively short-term nature of the MACs alleged in some cases, one wonders if private equity buyers asserting the same MAC allegations might not have the same leverage in the wake of the Hexion decision. Some commentators have argued that perhaps Hexion marks a shift in the nature of the relationship between buyers and sellers and acts as a potential roadmap for sellers seeking to challenge a potential MAC claim. As a result of Hexion, we may see more sellers resisting overtures by buyers to renegotiate or terminate a transaction.

Specific Performance

Specific performance is an equitable remedy generally available to courts. However it is typically reserved for circumstances where damages will not be an adequate remedy. It is rarely awarded in relation to M&A transactions, is difficult to justify and, until recently at least, it is almost unheard in a cash deal. There are now two high-profile examples in the United States of courts awarding specific performance in the context of an M&A dispute.

The Hexion Experience

As noted above, in addition to addressing the MAE clause, the Hexion decision addressed Hexion’s application for a declaratory judgement that Huntsman would be insolvent if the deal proceeded as planned. This would have let Hexion off the hook for all liability but the reverse break fee. The court instead concluded that Hexion had knowingly and intentionally breached the merger agreement. As a result of this finding, Hexion’s liability was no longer limited to just a reverse break fee of US$325m but extended to any other damages Huntsman might be able to prove as well. Further, the court enjoined Hexion and related parties from taking any further action that would impair, delay or prevent the completion or financing of the transaction.

In addressing the actions of Hexion in the months leading up to the application to court, Hexion’s view is that its actions did not constitute a knowing and intentional breach of the merger agreement on the basis that it did not have actual knowledge that its actions would amount to a breach of contract.

The courts concluded that Hexion’s actions amounted to a "deliberate act, which act constitutes in and of itself a breach of the merger agreement, even if breaching was not a conscious object of the action." As such, Hexion’s actions with regard to covenants to use reasonable best efforts to secure financing to complete the merger were in breach. As mentioned above, the significance of this was that Huntsman’s damages would not be limited to the $325-million reverse termination fee, but other damages Huntsman could demonstrate it had suffered.

The decision also serves as a formidable reminder of the equitable power that courts can impose in some circumstances. Upon finding an intentional breach, the court ordered Hexion specifically to perform its obligations to use reasonable best efforts to secure financing. The court also held open the merger agreement and eliminated Hexion’s right to terminate until the court was satisfied that Hexion had fully complied with the order. The court further held that because the reverse termination fee provision was not an exclusive remedy for knowing and intentional breaches, Hexion’s liability for such breaches were not capped. The court stopped short of ordering Hexion to consummate the merger as it found that the specific performance provision of the agreement did not apply to Hexion’s obligation to close.

Ultimately, Huntsman’s victory has been somewhat hollow. Getting an order for specific performance is one thing. Enforcing it is another. The banks resisted completing the financing and Huntsman was not initial successful in court against the banks in its attempt to enforce their commitments. In the end, the banks determined they would not fund. Huntsman settled for what was described as $1 billion (consisting of a break fee of $325M, $425M in additional cash and $250M of convertible notes of Huntsman). The settlement was funded by the banks, Apollo and related parties.


As noted above, the Tennessee Chancery Court ordered Finish Line to specifically perform the terms of its merger agreement with Genesco. This included closing the merger, using its reasonable best efforts to take all actions to consummate the merger, and using its reasonable best efforts to obtain financing. In the end, the parties ultimate settled as opposed to proceeding with the transaction. UBS and Finish Line paid US$175M, and in addition Genesco acquired a 12% interest in First Line’s stock.

Reverse Termination Fees

There have been a number of deal term innovations developed by private equity sponsors and their advisors as part of the recent leveraged buyout transactions. Reverse termination fees were initially adopted as a cap on damages payable by private equity sponsors. It is generally thought they were agreed to (initially in the 2005 buyout of SunGard) in consideration for agreeing to remove a financing out condition in favour of private equity sponsors.

A reverse termination fee is typically structured as a fee payable by the special purpose acquisition vehicle used in the transaction and is payable in the event the buyer fails to close (assuming all conditions to be met by the target company are satisfied). The reverse termination fee is coupled with a limited recourse guarantee by private equity sponsors providing the equity commitment to fund the acquisition vehicle on closing — as the special purpose vehicle is typically a shell entity without assets until closing. In most cases the guarantees have been limited not only to the quantum of the reverse termination fee but also to the circumstances in which they apply.

Variations have developed that are more favourable to the selling party. Hybrid reverse termination fees provide for a lower fee payable if the private equity sponsor fails to complete the transaction for lack of financing, and a higher fee payable by the private equity sponsor if it fails to complete the transaction when all other conditions including financing were satisfied. Another variation structures the reverse termination fee such that it is coupled with a commitment to allow the shell acquisition vehicle to specifically perform and enforce the debt and equity commitments if equity or debt is not available. In such cases, recourse is typically limited to just the reverse termination fee amount.

In some transactions the reverse termination fee is structured such that it is the sole recourse for some but not all breaches. Critics argue that the typical reverse termination fee structure effectively creates simply an ‘option’ on the target company for the private equity sponsors. In most cases, if they cannot get financing, they can simply walk with limited liability.

Target companies agreed to these structures based on certain assumptions and expectations. It was generally thought that private equity sponsors and their lenders had a reputational risk if they just walked. Similarly, reverse terminations fees were sufficiently high (it was thought) and created a deterrent such that the private equity sponsors and their lenders would not be financially motivated to simply terminate, pay the reverse termination fee and walk. These conclusions reached at a time when credit markets were generally healthy and there was limited risk (it was thought) that the debt would be available on reasonable terms.

The credit crisis revealed this weakness in the typical private equity structure. Faced with the expectations of very significant losses if deals were completed on the terms they were initially struck, some private equity sponsors (and their lenders) would prefer to pay a reverse break fee and simply walk away rather than close or even renegotiate more favourable terms.

United Rentals

The decision in United Rentals provides colour regarding the interpretation and application of reverse termination fees provisions. See also the Hexion discussion above. In the case of United Rentals, the purchaser, an entity established by Cerberus, had attempted to terminate its agreement to acquire United Rentals. Cerberus did not even attempt to assert the presence of a material adverse change as justification. Rather, it simply invoked the reverse termination provision of the acquisition agreement. United Rentals sued the Cerberus’s shell subsidiaries in Delaware court, challenging their attempt to terminate the agreement. United Rentals asked the court to require specific performance of the shell subsidiaries’ obligations.

The dispute centred on contract interpretation. Had the parties negotiated a pure reverse termination fee or a structure allowing for specific performance as an additional remedy? United Rentals argued that the contract provided for specific performance of the shell subsidiary entities’ financing commitments. Only if the financing failed could the Cerberus shell terminate the agreement. In contrast, Cerberus argued that the same language of the contract barred specific performance and that their only liability was $100 million. The contract was, unfortunately, drafted in an ambiguous manner. The case ultimately turned on a consideration of contract interpretation principles and concluded in favour of Cerberus’s reading of the agreement. Cerberus subsequently terminated the agreement and paid United Rentals the $100-million termination fee.

The United Rentals case provides a telling example of another circumstance where the private equity fund appeared to raise little concern with regard to interpretational risk, and concluded for economic reasons that its interests were simply better served to pay a reverse break fee and move on, as opposed to finding some way to comprise and preserve the deal.


As discussed above, the Hexion merger agreement included a hybrid reverse termination fee structure, in which payment of a reverse termination fee is the exclusive remedy only where a failure to close was due to the unavailability of debt financing to the buyer that otherwise had not breached its obligations under the agreement — that included an obligation to use reasonable best efforts to secure debt financing. The outcome highlights the risks of a "hybrid" reverse termination fee structure. It invariably will be difficult to determine why financing might not be available. As such the hybrid structure creates opportunities for dispute between parties.

Some Take-Away Thoughts for Future Deal Term Disputes

For the most part, the disputes in question come down to a contract interpretation exercise. It is unlikely that the cases discussed here would have ended up before the court if the agreements in question had been well-drafted. It is also reasonable to surmise that absent the inconsistencies, ambiguities and errors noted above, many of these disputes (whether before the courts or not) would have settled for smaller amounts. Ambiguities and the like may be used to advantage or disadvantage depending on your perspective.

These decisions also highlight the inter-connected nature of provisions in these agreement or related agreements. These drafting considerations extend to so-called boilerplate and miscellaneous clauses such as no reliance, exclusive remedy and entire agreement. These and other often overlooked terms can have a significant and perhaps unintended impact on how an agreement may be interpreted or may limit the arguments that may be raised if a dispute does arise.

When there are ambiguities or inconsistencies, the court may look outside the terms of the agreement itself. Parties should work from the premise that the courts will turn to parol evidence as part of the process. A careful review of records will be important. Similarly, as part of the discovery process documentary evidence of other parties to the dispute may be used to advantage.

We witnessed a strong sellers’ M&A market prior to the credit crisis. This led to the growth in MAC carve-outs and other seller-favourable deal terms. This was part of a general shifting of risk to buyers. We can anticipate a trend back to more buyer-centric agreement terms given that buyers now hold a better hand in negotiations. This may result in more deal-specific MAC clauses with targeted, fact-based triggers (e.g. EBITDA or earnings per share drops below a certain threshold). This may act as an alternative to relying on a general MAC clause — given the high bar courts have established for proving a MAC. Also, taking advantage of a MAC clause carve-out appears to present a challenge. If the Hexion analysis stands — that being, in order to consider the impact of the carve-out, determination of a MAC itself is first required. This may prove overly burdensome, so concepts addressed in a carve-out, such as an add-back for industry specific impact on a business, might be dealt with more effectively in a specific condition or representation.


So the markets are down. Many transactions that were struck with great fanfare a short time ago have fallen by the wayside. Some of deals that did close are now ridiculed. What then is left behind? It is worth noting here a quote attributed to Albert Einstein: "The definition of insanity is doing the same thing over and over again and expecting different results." It may be small solace, but perhaps some of these court decisions (and other high-profile disputes that were ultimately settled) can provide guideposts that will assist in avoiding the same errors and missteps in the future.