Deal Protection and Broken Deals: Questions of Material Adverse Change, Specific Performance and Reverse Termination Fees
The recent failure of several high-profile M&A transactions in the wake of the credit crunch that began last July has cast a spotlight on the negotiation and drafting of "deal protection" clauses in merger agreements, and the remedies available to a target company where a buyer seeks to renegotiate or walk away from a deal with no or limited liability.
Recent U.S. court decisions in two such transactions provide interesting lessons for companies and their advisors regarding the remedies available to targets and buyers, the conduct of negotiations, the drafting of key deal protection clauses and the importance of sustained due diligence on the target company.
In both Genesco, Inc. v. Finish Line, Inc., UBS Securities LLC et al. and United Rentals, Inc. v. Ram Holdings, Inc. et al, the courts addressed a target company’s claim for specific performance of a merger transaction which the buyer sought to abandon. In the United Rentals decision, the Delaware Chancery Court upheld the contractual right of a private equity buyer to walk away from its proposed buy-out by paying a reverse termination fee. In contrast, in the Genesco decision, the Tennessee Chancery Court ordered the buyer to complete its acquisition of the target.
The United Rentals and Genesco decisions highlight two important M&A trends of the last two years. The first has been the emergence of the reverse termination fee, introduced primarily in private equity transactions to replace the financing out condition which was traditional in those transactions prior to 2005. In many private equity M&A transactions, the payment by the buyer of a reverse termination fee – generally between 3% and 5% of the total transaction value – is often the seller’s sole recourse for a buyer’s failure to complete a transaction. Indeed, the United Rentals case arose from a fundamental disagreement between the parties as to whether the seller’s recourse was in fact limited in this manner. A second trend has been the increased willingness of buyers to invoke "material adverse change" or "MAC" (or "material adverse effect") clauses in their merger agreements in an attempt to abandon transactions without having to pay the reverse termination fee or as leverage against the seller to reduce the purchase price. The recent downturn in private equity-led M&A activity, as well as the numerous failed-deal lawsuits currently underway, are likely to see increasing attention being paid to ‘deal protection’ terms in merger agreements, and possibly a shift toward increasingly buyer-friendly remedies.
The United Rentals/Cerberus Decision
On July 22, 2007, United Rentals, Inc. (URI), the largest equipment rental company in the world, announced that it had entered into a merger agreement with entities controlled by Cerberus, a private equity firm, under which Cerberus would acquire URI for approximately $4 billion. In November 2007, following approval of the transaction by URI’s shareholders, Cerberus declared that is was unwilling to proceed with the transaction, citing deteriorating conditions in the credit markets. In its letter to URI, Cerberus declared that it was prepared to either negotiate a reduced purchase price or pay to URI the $100 million reverse termination fee contemplated in the merger agreement. Cerberus did not claim that URI had suffered a material adverse change, as changes in credit market conditions were specifically carved out of the MAC clause in the merger agreement.
URI brought suit in the Delaware Court of Chancery seeking specific performance to compel Cerberus to complete the transaction. In response, Cerberus argued that the merger agreement precluded URI from seeking any remedy – including specific performance – other than the $100 million reverse termination fee payable by Cerberus.
Central to the arguments of each party was the interpretation of the remedy clauses in the merger agreement, which were ambiguously drafted. Although the agreement contained a broadly drafted specific performance clause, which supported URI’s position, the clause was made subject to another provision in the agreement which expressly limited URI’s remedies in connection with any breach of the agreement to the payment of the $100 million reverse termination fee.
In reviewing the merger agreement, the Delaware court concluded that both URI’s and Cerberus’s interpretations were reasonable, and ordered that a short trial be held to determine the common understanding of the parties with respect to the remedies under the merger agreement. Following an in-depth review of the negotiation and drafting history of the merger agreement, the court concluded that the evidence did not lead to an obvious, objectively reasonable interpretation, and instead relied on an obscure rule of contract negotiation referred to as the "forthright negotiator principle." Under this rule, a court may consider, and impose on both parties, the subjective understanding of one party where this understanding has been objectively manifested and is known or should be known by the other party, and the opposite is not true.
Applying this test, the Delaware court concluded that both parties had engaged in a "deeply flawed negotiation in which neither clearly and consistently communicated their client’s positions". However, the court determined that Cerberus had clearly indicated to URI and its counsel its view that the transaction was an ‘option deal’ that it could walk away from without any liability other than payment of a reverse termination fee. By contrast, the court determined that URI had "categorically failed" to communicate its client’s understanding that it had preserved a right to specific performance. Because URI knew or ought to have known Cerberus’s understanding of its remedies, but failed to clarify its own contradictory position, its petition for specific performance was denied.
Shortly after the Delaware court released its decision in December 2007, URI terminated the merger agreement and Cerberus paid to URI the reverse termination fee.
The Genesco/Finish Line Decision
On June 17, 2007, Finish Line and Genesco signed a merger agreement for Finish Line to acquire Genesco for approximately $1.5 billion. The merger agreement provided, among other things, that if the transaction was not closed by December 31, 2007, either party could terminate the transaction. Unlike the United Rentals/Cerberus merger agreement, the Genesco-Finish Line merger agreement did not contain a reverse termination fee and clearly stipulated that either party was entitled to an injunction to prevent breach of the agreement.
A few months after the merger agreement was signed, Genesco’s quarterly earnings fell well short of projections, and were the lowest they had been in ten years. Genesco obtained shareholder approval for the merger and demanded a closing, but UBS Loan Finance LLC, which was providing the acquisition financing, refused to proceed without additional financial information.
On September 24, 2007, Genesco filed suit in the Tennessee Chancery Court asking for the court to compel Finish Line and UBS to complete the acquisition before the December 31, 2007 termination date. Finish Line and UBS argued that they were not obligated to close the transaction either because Genesco had suffered a material adverse effect (MAE), or because Finish Line had failed to receive material information concerning Genesco’s financial performance in May of 2007 and updated financial projections prior to the signing of the merger agreement.
After a rapid trial (from December 10 to December 18, 2007, with memorandum and order issued on December 27, 2007), the Chancellor found that Genesco had suffered a material adverse effect (as defined in the merger agreement), but that the MAE was due to general economic conditions and Genesco’s decline in earnings was not disproportionate to its peers in the industry. This fell within one of the exceptions to the definition of the MAE in the merger agreement and consequently did not excuse performance by Finish Line.
The Chancellor also found that Finish Line and UBS had failed to prove that Genesco fraudulently induced Finish Line to enter into the agreement by not providing the material information regarding Genesco’s May 2007 results. The court found that Genesco’s May 2007 results had not been calculated at the time UBS requested them on behalf of Finish Line and that neither the law nor the parties’ agreements required Genesco or its advisor to provide the information voluntarily once it became available. The court stated plainly that "[t]he fault is with Finish Line’s advisor UBS for not requesting the information."
The court ordered that all conditions to the merger agreement had been met and required Finish Line to specifically perform the terms of the merger agreement, including,
- 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.
The court, however, specifically did not rule on any issues as to the solvency of the merged entity. Although a letter attesting to the solvency of the merged entity was a pre-condition to the financing, a similar condition was not included in the merger agreement. UBS has filed a lawsuit in New York seeking to void its commitment letter, on the grounds that Finish Line will not be able to deliver the solvency certificate required to close the financing. As at the end of January, it was reported that Finish Line and UBS intended to appeal the Tennessee ruling.
McCarthy Tétrault Notes:
Although their applicability in the Canadian context is uncertain, the Genesco and United Rentals cases are instructive. Companies engaging in M&A activity, as well as their financial and legal advisors, should bear in mind the following points:
The Genesco case represents an interesting development where specific performance, instead of damages, was awarded in a cash transaction. This represents a significant departure from previous case law. While injunctive relief is often specifically contemplated by the provisions of a merger agreement, it is rare for courts to award it where damages would be an adequate remedy.
Reverse Termination Fees
Sellers need to understand the implications of the reverse termination fee structure. In United Rentals, the reverse termination fee in effect turned the merger agreement into an "option" for the buyer to acquire the company – an option which Cerberus chose not to exercise.
Both the United Rentals and the Genesco cases highlight the importance of careful drafting of key provisions of merger agreements, particularly where these provisions are made to interact with other provisions in ways that attempt to limit or modify their scope. When drafting MAC clauses, acquirers should consider not only general economic conditions, but industry specific and even company specific conditions. Of course, relative bargaining power will determine whether the buyers’ or the sellers’ drafting prevails.
Parties should also ensure that the closing conditions to acquisition financing are mirrored in the merger agreement to avoid a situation like the one in Genesco, where the solvency condition included under the financing arrangements was not included as a condition of the merger agreement.
"Forthright Negotiator Principle"
The "forthright negotiator principle" articulated by the Delaware court is probably restricted to an unusual fact situation where extrinsic evidence did not resolve a contractual ambiguity. As a general rule, Canadian law does not currently recognize the "good faith" requirement in the negotiation of agreements.
The Finish Line decision indicates that courts may not penalize a party for responding only to specific information requests and not providing updates where these have not been requested by the other party. This highlights the importance for buyers to continue their due diligence review process through to the signing of an acquisition agreement and beyond.