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Should the current strain in the credit markets prompt banks or sponsors to attempt walking away from deals, avenues of litigation exist but are highly conditional on each particular merger agreement, legal M&A deal sources said.
One lawyer explained that the issue of whether a buyer could walk away from a deal, possibly as a result of financing, revolves around three contractual issues between the sponsor and the target: the reverse break-up fee and under what circumstances it is payable, what happens as the result of an intentional breach, and, lastly, how specific performance is treated as a remedy.
The most well known of the issues is the reverse breakup fee, payable to the target in the event that all merger conditions are satisfied but financing failures prohibit closure.
Intentional breach of contract was explored recently in a published article regarding KKR’s buyout of TXU and the possibility of Citigroup paying the sponsor’s break fee in lieu of financing the transaction. In this scenario, Citi, faced with the prospect of lending into a situation where it would have to fund the bridge in the event loans could not be syndicated, would likely take a far less severe financial hit in paying KKR’s reverse breakup fee to walk away from the deal. KKR, or any sponsor in more risky LBO situations, could be inclined to take the offer into consideration as financing becomes increasingly expensive and equity placements face far greater risk, said the lawyer.
The fee associated with an intentional breach is often higher than the traditional reverse break up fee of around 3%, and can go as high as 10%, according to the lawyer. However, the intentional breach may only be implemented if the sponsor has used reasonable best efforts to obtain the financing.
As a result, a private equity source said he would sooner tell the bank to fail in its syndication, invoking the traditional breakup fee, before pursuing the intentional breach.
The possibility of allowing banks to pay a sponsor’s reverse break-up fee would set a terrible precedent for the buysiders on future deals, putting each institution’s credibility at risk, said Mark Joachim, a partner in Bracewell & Guilliani’s finance practice. The first lawyer agreed, saying, “It won’t do much for the bank’s reputation to be seen as paying off buyout firms to walk away from deals.”
However, the market is skeptical as to whether the banks would even risk whispering into the ear of the sponsor, said the lawyer. Such an act could be viewed as tortious interference, he said, a term defined as “a third party’s act to intentionally and willfully interfere and break a contract between two parties, causing damage to the relationship between those contracting parties.” This would be a tort claim and not a contract claim, as the bank and target are not in a contractual agreement, he added, allowing for the target to sue the bank directly.
But the bank could, in turn, challenge its financing commitment letter to a sponsor, saying it is not binding, said one lawyer. While each commitment letter is different, they are typically subject to the execution and delivery of binding agreements, he said. If no binding agreement has been executed and delivered, a court could question whether the commitment letter is, in fact a commitment, he said.
The last component of deconstructing what claims a target may have in the event a buyer walks deals with the specific performance provision, said the lawyer. Specific performance is defined as “the right of a party to a contract to demand that the defendant (the party who it is claimed breached the contract) be ordered in the judgment to perform the contract.” Most deals, he said, have a provision that says specific performance cannot be given against the buyout shop; otherwise, it would undermine the value of the reverse breakup fee, he said.
There have been recent exceptions in this arena as both the Free Scale and Harrah’s LBOs included specific performance in their mergers, the lawyer said. In these cases, there is a covenant in the agreement between the sponsor and target (not the bank) saying the sponsor must close using reasonable best efforts to collect the debt from those commitments if the debt is available, he said. The debt is available on all of these deals, the lawyer said, with the bank being forced to absorb any financial losses from financing if syndication fails. Thus, a sponsor is not given an option on the company and must go to the bank to demand financing and force the close.
But the lawyer agreed that the aforementioned potential claims a target may have against a buyout group in the event the latter walks away have no precedent as most deals up until around 2005 had financing conditions. Because this is the first time any of these issues are “coming to roost,” many of these provisions would only be stress-tested now, he said, on highly leveraged deals such as First Data and TXU.
These strong-arm tactics, particularly on the part of influential LBO shops to force banks to absorb the entire financial burden of deals in the choppy market, is seen as posturing, said the lawyer. Overall, few M&A sources believe this type of litigation will need to be pursued because most banks and sponsors are collaborating with modified financing terms during the market tumult.
“My sense is that the equity sponsors and the banks are working together, trying to make this a soft landing because the last few years have been a great feeding frenzy for both sides. They are not going to kill it by suing each other,” said Joachim.
Even if banks and sponsors bend on terms, the question of legal recourse for a target or its shareholders as the result of a delayed closing was raised. In the event a drop dead date is extended due to credit conditions, the PE source said he could see a target seeking an amended deal price. In most cases, the uncertainty of deals closing is not due to target underperformance, he said, pointing to the ramifications of an uncertain credit market; as such, the company could possibly think it was worth more when a deal went to be financed later than originally scheduled, he said.
If a deal is entirely renegotiated with an extended drop dead date to accommodate the bank’s desire to not hold the bridge loan on their books, then a company’s investors should presumably have some leverage to possibly seek better terms, commented a second lawyer. He said the market has changed so much that what the banks are terrified about is having to keep tons of paper on their books and write it down at a loss right away. In other words, there are no better terms to give, explained the lawyer. “I think it’s an uphill fight to say get interest on the deferred payment on the purchase price. In most of these cases, I think the sellers are going to be delighted to see a closing,” said a third lawyer.
A banker agreed, saying any chance for a price increase was zero if a deal lapsed, pointing to Lear, and saying he thought some shareholders and hedge funds were playing a game in asking for money - only to be denied and see the share price plunge.
As for individual shareholder recourse, once a deal has been voted on, a target stockholder generally has no ability to obtain a remedy on an individual basis, said a fourth lawyer. He said he has been receiving many inquiries as to whether the current credit market conditions constitute an MAE (Material Adverse Effect) or MAC (Material Adverse Change.)
Negotiations surrounding the formation of a MAC usually focus on the following liabilities as per a previous legal report on the matter: failure to hit financial targets and projections, significant litigation loss, regulatory environment change, a drop in the share price of the publicly traded target, loss of a key customer contract, or fraud.
While each merger agreement varies to some point, a MAC is defined as “a change, circumstance or effect that is or is reasonably likely to be materially adverse to: (i) the business, financial condition, prospects or results of operations of the company and its subsidiaries taken as a whole, other than any change, circumstance or effect relating (x) to the economy or financial markets in general or (y) in general to the industry in which the company operates; or (ii) the ability of the company to consummate the transactions contemplated by this agreement.”
In the last few years, companies have been agreeing to pared down MACs without many conditions, making it more difficult to trigger a MAC, said Joachim. A MAC cannot be triggered in response to general market conditions. Even if negative market events affect the company in question, it only constitutes a MAC if it affects this particular company more than any other companies in the same space, he said.
A target stockholder could assert a derivative claim on behalf of the corporation for breach of the merger agreement, a claim to enforce the corporation’s right to close, the fourth lawyer added. However, it is unlikely that a stockholder could bring such a claim on a third party plaintiff, he said.
When asked if the current market would promote litigious behavior, one of the lawyers said to wait and see how long the volatility lasts, with most trying to wait until after Labor Day before getting too panicky. An extended strain on the credit market will determine the legal backlash, he agreed.
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