Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion

by Steven M. Davidoff

  There was also the role and effect of exclusions on a MAC. Prior to the Accredited dispute, no courts had interpreted or looked at the effect of the MAC exclusions on a MAC claim. This was not surprising. The development of MAC exclusions was a recent phenomenon, and even the MAC clause in the Tyson’s deal did not contain any. In the past decade, though, carve-outs had multiplied and become standard. One study found that by 2005, the average MAC clause had 6.5 carve-outs.29 This was a drastic change when compared with MACs in the early 1990s, when only 20 percent of those had even contained a carve-out.30 These carve-outs came in all types. In its 2007 MAC survey, the law firm Nixon Peabody listed 32 different types of carve-outs.31

  The stunning growth in carve-outs and the reasons for their rise pose a puzzle. The carve-outs favored the seller but, in some respects, largely replicated the consensus MAC interpretation. The buyer was assuming the general risk while a MAC was meant to pick up significantly adverse events affecting only the seller. An exclusion for changes to the industry or the economy to a large extent duplicated what was already embedded in the commonly understood MAC definition.

  But attorneys could use negotiated carve-outs to show value to clients. The more or fewer carve-outs negotiated, the better the job the lawyer could show to the client. The number reflected the bargaining power of the parties. Hence, it was no surprise that one study found that the more MAC carve-outs, the more likely the deal was to close.32 Not only did carve-outs limit the outs of a buyer but also the number reflected a buyer’s willingness to buy. The result was carve-out creep. New exclusions were being negotiated yearly, and the standard MAC was running 10 to 20 lines of text.Yet the scope and interpretation of these carve-outs had yet to be judicially addressed.

  When Lone Star made its MAC claim, it thus had the guidance of IBP and Frontier but no answers to these open questions. The parties’ arguments in this dispute unfolded around these uncertainties. Accredited’s defense avoided the question of whether a material adverse change had occurred. It almost certainly had. Accredited was about to go bankrupt without this acquisition. Rather, Accredited argued that one of the 13 exclusions applied or, conversely, the events Lone Star now claimed to be a MAC were known at the time.

  This left a number of areas for both Lone Star and Accredited to litigate. For example, under this standard MAC exclusion, was Accredited’s performance really worse than others in the industry? Since early 2007, a significant number of mortgage brokers or originators had filed for bankruptcy. Materially disproportionate in this circumstance was almost undefinable. What was disproportionate anyway? Was it a dollar worse than everyone else, or did it have to be significant or constitute a material adverse effect in and of itself? There was literally no law on this.

  The MAC Wars of Fall 2007

  The Accredited MAC quarrel was one of the first of a number to emerge in the fall of 2007. These MAC disputes largely followed the same pattern as the Accredited litigation. The parties largely focused their arguments on the exclusions to the MAC clause and whether and how they were implicated.

  Almost at the same time as Accredited’s misfortunes, Radian Group Inc., a company in the subprime mortgage lending business, suffered a similar MAC claim. Radian had agreed to a merger of equals with rival Mortgage Guaranty Insurance Corporation (MGIC) in a deal valued at almost $4.9 billion when announced. On August 7, 2007, MGIC publicly disclosed that it believed a material adverse change had occurred with respect to Radian. MGIC claimed a MAC based on a $1 billion loss suffered by C-Bass LLC, a subprime loan subsidiary jointly owned by MGIC and Radian.33 The MGICRadian MAC dispute raised a similar issue as the Accredited one, namely, the question of whether the adverse event to Radian was disproportionate under the industry exclusion in their agreement’s MAC clause.

  On August 21, 2007, MGIC sued Radian in federal district court in Milwaukee to obtain information from Radian to definitively determine whether a MAC had occurred.This tactic was not uncommon in the MAC wars of 2007. The buyer would make a claim that a MAC might have arisen but not actually claim one, instead suing to force the target to provide more information for such a determination. This maneuver allowed the buyer to stall for time and attempt to settle the claim while preserving its option to complete the transaction. MGIC’s suit in Milwaukee also highlighted the importance of forum selection clauses in these disputes. The MGICRadian acquisition agreement stipulated that the parties accepted jurisdiction for any suit in the courts of New York. However, this was not a mandatory requirement. MGIC was therefore able to sue in a Milwaukee court, its headquarters, establishing home court advantage for any subsequent MAC litigation.34

  Two weeks later on September 5, the parties suddenly and jointly announced the termination of their transaction. This was the first deal during the emerging financial crisis to be terminated on MAC grounds. It was also a clean break, and neither party paid any funds to the other. This was a bit surprising. Based on the publicly available facts, Radian appeared to have reasonable grounds to deny that a MAC had occurred. C-Bass, the affected subsidiary, was jointly owned by the parties, and the MAC industry exclusion in their agreement provided a firm defense that Radian’s troubles were borne equally by the entire industry. Nonetheless, Radian chose to drop its claims. Presumably, Radian was much more aware of the facts of their case. Radian’s shareholders were to receive stock in the combined entity, and so Radian may no longer have viewed MGIC as a particularly good investment. The settlement also highlighted why there is so little case law on MACs. The parties typically resolve these cases by terminating the deal or renegotiating the price, rather than going to trial. As was also typical in these disputes, neither Radian nor MGIC disclosed any significant information about the merits of each party’s case or the reasons for settlement.

  The largest MAC dispute to arise during this period was the October 2007 litigation surrounding the $25.3 billion buy-out of SLM Corp., otherwise known as Sallie Mae, by a consortium led by the J.C. Flowers Group. In that dispute, the J.C. Flowers Group, and its partners Bank of America Co. and JPMorgan Chase & Co., alleged that Congress’s new student education bill, the College Cost Reduction and Access Act of 2007, had resulted in a MAC to SLM.35 SLM countered that this legislation was not a MAC because the MAC clause in their agreement specifically excluded:

  changes in Applicable Law provided that, for purposes of this definition, “changes in Applicable Law” shall not include any changes in Applicable Law relating specifically to the education finance industry that are in the aggregate more adverse to [SLM] than the legislative and budget proposals described under the heading “Recent Developments” in the Company 10-K… . 36

  This double-negative clause excluded changes from applicable law out of the MAC definition. The Congressional bill was surely that. However, the clause then put back into the MAC clause any changes engendered by legislation that were collectively more adverse than disclosed in SLM’s annual report filed with the SEC on Form 10-K. The parties seemed to agree that the Congressional bill was a material adverse effect on SLM causing a significant long-term decline in its earnings. However, the parties disputed whether the change was more adverse than what was in the SEC filings. The Flowers consortium argued that disproportional needed to be only $1 more, while SLM argued disproportional was something materially adverse.37

  The contract language favored Flowers. The parties had bargained for this legislative change, and the risk appeared to have been allocated to Flowers only up to what had been disclosed in SLM’s 10-K. But the chairman of SLM, Albert L. Lord, took the whole thing personally, attending the hearings in Delaware and arguing that this was not the case. At first, he refused to settle for anything less than the initial price the Flowers consortium had agreed to pay. Lord rejected a renegotiation offer by the consortium to reduce the consideration from approximately $60 a share in cash to $50 a share in cash and $7 to $10 a share in warrants.38 Market observers called Lord’s stance foolish, one based on his ego-driven view of SL
M and the transaction. Lord too late came to agree with these observers, after the Flowers group withdrew their offer. By December 2007, Lord was reduced to arguing for a deal at any price, stating: “The [original] objective was to do a transaction at $60 [per share]. The ongoing objective is to do a transaction at a price that shareholders would accept.”39

  In the SLM and Accredited cases, we were left with no judicial answer as to whether a MAC actually existed. The better argument in the Accredited case appeared to be that the MAC was excused because Accredited’s failings were no worse than what had happened in the general industry. Lone Star also knowingly bought into Accredited’s problems. Conversely, SLM seemed to be hit harder than expected and more disproportionately than others in its industry, an event that put them outside the safe harbor of their specifically bargained-for MAC exclusion.

  The uncertainties over the scope and meaning of these clauses played out as they typically do in MAC disputes—toward settlement. On September 19, 2007, Accredited announced that it had settled its dispute with Lone Star and agreed to be bought out for $11.75 a share. The fact that the price was relatively close to the original one of $15.10 per share reflected the parties’ assessment of the risks of litigation. Accredited’s troubles were being experienced throughout the mortgage industry and were driven by the general decline in the economy and the housing market. These supported a strong argument against Lone Star’s MAC claim.

  SLM, after a management upheaval, settled in exchange for a new financing package from Bank of America and JPMorgan Chase & Co. The deal was canceled, but this was probably due to the existence of a private equity acquisition structure that capped the liability of the SLM buyers to a maximum of $700 million. The settlement amount was hard to calculate but appeared to be far less than the $700 million cap. Again, the settlement reflected the relative merits of the parties’ claims and appeared to show that SLM lost badly.

  Accredited and these other early MAC cases set an example. Going into the financial crisis, any MAC claim was likely to face a high hurdle and would probably depend on the applicability of the MAC exclusions. Still, even a colorable MAC claim could work to advantage a buyer and force a settlement. Here, as J.C. Flowers found to its benefit in the SLM dispute, the wording of the MAC could make the difference in the scope and amount of the settlement. This would lead to more creative deal-escape strategies as the financial crisis progressed into 2008 and it became increasingly difficult to prove a MAC in light of the general downturn.

  The MAC Clause in Flux

  The two major MAC cases to go to trial during this time highlighted the difficulty of establishing a MAC claim in court. The first of these was the litigation between the shoe retailers Genesco Inc., and The Finish Line Inc.The Genesco-Finish Line dispute was perhaps the most unfortunate of the fall 2007 period. In an auction before the financial crisis, Finish Line had outbid Foot Locker, Inc. to acquire Genesco. Finish Line was the minnow swallowing the whale. Finish Line was a third the size of Genesco; to pay for the deal, it was going to borrow almost the entire $1.5 billion purchase price from its investment banker, UBS AG.40 After the announcement of the deal, the market jeered at this extreme leverage, and Finish Line’s stock slumped.

  In August 2007, Genesco announced disappointing quarterly earnings. Finish Line’s banker and investment adviser UBS promptly abandoned Finish Line. UBS claimed that the combined entity would be insolvent and that it was no longer obligated to finance the acquisition.

  Unfortunately for Finish Line, its lawyers had negotiated an agreement that did not contain a financing condition and provided for specific performance of the agreement. Finish Line was left obligated to consummate an acquisition that it couldn’t pay for and its shareholders did not want. Instead, it did the only thing it could do; it asked the court to declare that a MAC to Genesco had occurred.41

  This case was different. The acquisition agreement was governed by Tennessee law and selected Tennessee as the forum for all disputes. This was not a Delaware case, with experienced judges and courts versed in business disputes and the governing precedent. Rather, the judge, though quite intelligent, was a local judge in Nashville, and this appeared to be her first significant national business dispute.

  It was also the first MAC case to be litigated in Tennessee under the laws of that state. The opinion in the dispute reflected this.42 The judge in the case found that there was no MAC because the MAC exclusion for general economic conditions applied.The court relied on Genesco’s expert testimony that high gas, heating, oil, and food prices; housing and mortgage issues; and increased consumer debt loads were generally responsible for Genesco’s condition. She also found that Genesco’s decline was not disproportionate to others in the industry and, therefore, no MAC had occurred. The opinion did not provide any guidance beyond the unique situation of the parties or on what exactly disproportionate means. Because of this, it is likely to have little precedential effect on future MAC cases. Like most other MAC cases, the Genesco-Finish Line dispute was ultimately settled before appeal. It was a smart move for Finish Line. If it had lost, Finish Line would have probably faced bankruptcy. UBS, which had turned on Finish Line, its own client, escaped with a small payment to Genesco of $136 million,43 small penance for its misdeeds and betrayal.

  The second MAC opinion issued during the financial crisis came later in September 2008. It was issued by Vice Chancellor Stephen P. Lamb in the litigation between the chemical makers Huntsman Corp. and Hexion Specialty Chemicals, Inc. Hexion, a portfolio company of the private equity firm the Apollo Group, had agreed to acquire Huntsman back in the heady days of July 2007, beating out a competing bid by the Dutch chemical company Basell AF. The deal had remained outstanding into 2008, as the parties waited for regulatory clearances and Hexion developed a case of buyer’s remorse. When these regulatory approvals appeared imminent, Hexion finally could delay no longer and sued Huntsman in Delaware Chancery Court, claiming that it was no longer obligated to complete the acquisition because the combined entity would be insolvent and, in any event, Huntsman had experienced a MAC.44 At the time of the suit, Peter R. Huntsman, the founder of Huntsman, denied the claims and issued a statement:

  Apollo’s recent action in filing this suit represents one of the most unethical contract breaches I have observed in fifty years of business. Leon Black and Josh Harris [the heads of Apollo] should be disgraced. Our company will fight Apollo vigorously on all fronts.45

  Vice Chancellor Lamb agreed with Huntsman as to the validity of Hexion’s MAC claim. Lamb relied heavily on IBP to describe a MAC as being a “significantly durational” adverse event “expected to persist in the future.”46 In Huntsman’s case, there was no MAC to its business, since Huntsman’s 2007 EBITDA, or earnings before interest, taxes, depreciation, and amortization, was only 3 percent below its 2006 EBITDA. In addition, its 2008 EBITDA would be only 7 percent below its 2007 EBITDA. Lamb found that since EBITDA is independent of capital structure, it is a better measure of the operational results of a business for determining a MAC. Here, he held that the burden is on the buyer to prove a MAC, unless otherwise agreed by the parties.

  Moreover, to determine a MAC,Vice Chancellor Lamb refused to consider projections of Huntsman’s future performance, instead preferring to ascertain a MAC by reviewing a year-to-year comparison of results. He did not rely on projections because of standard disclaimers about reliance on projections in the parties’ acquisition agreement. He also implied that he would have done so even without this disclaimer language, as actual year-to-year earnings are a better measure of a MAC. This was a significant finding and largely eliminated any forward-looking element to the typical MAC. In this case, it made a difference. According to forecasts from Huntsman management, Huntsman’s EBITDA projections for 2008 have gone from $1.289 billion as of June 2007 to $863 million at the time of trial, a significant decline. This probably put Huntsman in the range of a MAC claim before the exclusions were accounted for.

  Vice Chanc
ellor Lamb finally ruled that the carve-outs to the MAC come into play only if there is indeed first a MAC. He rejected Hexion’s argument that “the relevant standard to apply in judging whether an MAE has occurred is to compare Huntsman’s performance since the signing of the acquisition agreement and its expected future performance to the rest of the chemical industry.”47 Hexion made this argument based on an exclusion in the MAC clause for changes in the chemical industry generally. Instead, Lamb first looked to whether a material adverse change had occurred to the Huntsman business before even turning to the exclusions. Since he found that no such material adverse change had occurred, he never looked to see if the exclusions applied.

  The Future of the MAC

  The great MAC wars of 2007 and the coda with Huntsman in 2008 confirmed the high bar a court would set before it would find a MAC. It also left open continuing questions about the scope of a MAC. In the period from August 2007 through August 2008, MAC claims were publicly made in approximately 5 to 10 transactions, with only 2 going to trial; the remainder settled before a judicial opinion could be issued. In both trials, the judge found that a MAC had not occurred. In fact, no Delaware court has found a MAC … ever. The consequence is that in future disputes, targets are likely to resist these claims in greater measure. Furthermore, the role and nature of the MAC exclusions appear to be increasingly important. Yet, the uncertainties as to the appropriate role and interpretation of these exclusions remain, even after the wreckage of these disputes had cleared.48