The recent Hexion Specialty Chemicals v. Huntsman decision (Del. Ch. Ct., Sept. 29, 2008, Vice Chancellor Lamb) highlights two important considerations for dealmakers:
- A “hybrid” or “toggle” reverse termination fee structure, in which payment of the reverse termination fee is the exclusive remedy only where the failure to close was due to the unavailability of debt financing to a buyer that otherwise had not breached its obligations under the agreement (including its obligation to use reasonable best efforts to secure the debt financing), can impose risks for a buyer due to the uncertainty inherent in determining, in hindsight, why in fact the debt financing became unavailable; and
- Delaware courts continue to set a high threshold for finding a material adverse effect or “MAE” that would excuse a buyer from completing its acquisition of a target.
In this case, Huntsman, a global manufacturer and marketer of chemical products, put itself up for sale in the midst of the M&A boom in May 2007. By the end of June 2007, Huntsman had executed a merger agreement with Basell AF, only to have that deal topped by Hexion (an Apollo Global Management-controlled portfolio company). When Hexion ultimately offered an additional $2.75 per share, Huntsman terminated its agreement with Basell and entered into a merger agreement with Hexion. Shortly after signing, Huntsman’s performance declined and the overall domestic credit markets deteriorated, leading Hexion to file suit. Hexion sought a declaratory judgment that (i) it was not obligated to close if the combined entity would be insolvent (thus making financing impossible to obtain), in which case its liability would be limited to the $325 million reverse termination fee, and (ii) Huntsman had suffered an MAE, in which case Hexion would not be obligated to close and would have no liability under the merger agreement.
The decision serves as a reminder of the Chancery Court’s formidable equitable powers.1 After finding that Hexion intentionally breached a number of its obligations under the merger agreement (including the obligation to use its reasonable best efforts to secure financing), the Court ordered Hexion specifically to perform such obligations and held open the merger agreement (eliminating Hexion’s right to terminate) until the Court is satisfied that Hexion has fully complied with its order. The Court further held that, because the reverse termination fee provision was not the exclusive remedy for knowing and intentional breaches, Hexion’s liability for such breaches was not capped at that fee and Hexion was instead liable for any damages proximately caused by those breaches. Ultimately, the Court stopped short of ordering Hexion to consummate the merger as it found that the specific performance provisions of the agreement did not apply to Hexion’s obligation to close.
This opinion is another example of the Chancery Court’s longstanding role as a champion of the concepts of “good faith” and “forthright negotiations” in contractual relationships. In United Rentals v. RAM Holdings (Del. Ch. Ct., Dec. 21, 2007, Chancellor Chandler), the Delaware Courts enforced a “pure” reverse termination fee structure (where the fee is the exclusive remedy against buyer in all situations). In Hexion, the Court noted that the buyer could have negotiated terms that would have better accommodated its needs, such as a financing or solvency condition. Instead, Hexion ostensibly gave up those options in its quest for a hotly sought-after target and, in this case, the Court held Hexion to what the Court found to be the benefit of its bargain.
And therein lies the rub. As is true in many litigations, this decision turns on a post facto judicial interpretation of contractual provisions and the parties’ actions in that context. The outcome highlights the risks of “hybrid” reverse termination fee structures that have become prevalent in buyouts, including in the Huntsman/Hexion deal. In the “hybrid” reverse termination fee structure, liquidated damages are the exclusive remedy under one set of circumstances (e.g., a failure of funding), but not under other circumstances (e.g., where the buyer knowingly and intentionally breaches the agreement). As it invariably will be difficult to determine why financing might not have been available, the hybrid structure creates opportunities for disputes between parties. Further, it can be difficult to predict the results of a judicial review of parties’ actions, particularly when such review occurs with the benefit of 20-20 hindsight.
Another significant aspect of the opinion is the Court’s finding that Huntsman had not suffered an MAE as defined in the merger agreement. The Chancery Court followed the longstanding principle set forth in IBP v. Tyson (Del. Ch. Ct., Jun. 18, 2001, Vice Chancellor Strine) and Frontier Oil v. Holly (Del. Ch. Ct., Apr. 29, 2005, Vice Chancellor Noble) that an MAE results only when “unknown events. . . substantially threaten the overall earnings potential of the target in a durationally-significant manner.” Underscoring what a high threshold this is, the opinion notes that Delaware courts have never found an MAE in the context of a merger. Further, the Court expanded on several other MAE points, including the following:
- The Court stated that in the context of a cash deal, as was the case here, the use of an earnings per share benchmark to measure MAE is “problematic” because EPS is “very much a function of the capital structure of a company, reflecting the effects of leverage.” In recognizing that cash buyers often reshape the capital structure of an acquired entity, the Court felt that pre-merger EPS is “largely irrelevant” in that context and that what matters are the results of operation of the business, namely measured by EBITDA. The Court leaves open the possibility that Delaware courts could, for MAE purposes, evaluate transactions involving financial buyers differently from strategic deals or interpret an MAE clause differently depending on the type of agreement at issue, e.g., a credit agreement as opposed to a merger agreement.
- The Court noted that whether an MAE has occurred could not be determined by the company’s failure to meet projections because reliance on such projections had been disavowed elsewhere in the agreement. Rather, it held that the proper analysis is a year-over-year and quarter-over-quarter comparison of the “financial condition, business, or results of operations” of the target per the terms of the MAE definition. The Court stated that such a comparison should be defined by reference to the similar analysis that occurs pursuant to Reg. S-X of the federal securities laws and Item 7 of Form 10-K under Management’s Discussion and Analysis of Financial Condition and Results of Operations. The Court found that an analysis of the future performance of the target is still relevant to an MAE analysis as a measure to be compared to historical performance.
- The Court also held that, absent clear contract language providing otherwise, the burden of proof with respect to establishing an MAE rests with the party seeking to excuse its performance under the contract, in this case, Hexion.