Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion
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A MAC creates option value for a buyer. It provides the buyer an ability to abandon the acquisition in certain adverse circumstances. Conversely, the target has its own option to put the company to the buyer at a set or renegotiated price.This is value that should be reflected in the deal price and the negotiation. But in practice, deal pricing generally occurs before the negotiation of the MAC. The details are worked out after price is agreed. The price and the bargaining power it implies drive the negotiation. This is arguably reflected in the number of exclusions.
The events of 2007 and 2008 confirm the most important reason for a MAC clause. A MAC provision is a prenegotiated bargaining tool to preserve value for the target and buyer. It allows the parties to ensure that if there is a significant deterioration of the target, both parties preserve value. The target does not lose entirely in such an instance, as it can still leverage the dynamics of a MAC to renegotiate the price, albeit for a lower amount. Similarly, the buyer can utilize the same dynamics to forgo paying the prior full price, paying a reduced amount. In both circumstances, the buyer is still purchasing the business for a reduced value that it finds acceptable taking into account litigation risk. This is a situation a target similarly finds itself in a MAC renegotiation. In light of the recent market events, a MAC is therefore best seen as a bonding device to ensure a renegotiation and loss sharing in the event of an adverse event. In other words, it is a form of insurance for both sides.49
It would thus appear that the point of a MAC clause as the fulcrum of the agreement has been lost. In England and other jurisdictions, agreements are simplified with a bare MAC. Lawyers no doubt find that they can show value to clients by negotiating 20 pages of representations and warranties that must be true as of closing if the buyer is going to be required to complete the acquisition. In the end, these are qualified by MAC and so in essence really just a form of MAC themselves. Moreover, the number of exclusions has grown, but in the repeated negotiation of these carve-outs has occurred a failure to recognize that the meaning and effect of these exclusions is unknown.
Only a few exclusions actually ever came into play in these disputes. The remainder appear to be gravy and boilerplate exclusions included on a pro forma basis with little meaning. How and why did we get here? It is time to rethink the wording and scope of MAC clauses. Unfortunately, change, if it comes, though, is likely to go in the opposite direction, making MAC clauses more complex rather than clearer and simpler.The reason is the role of lawyers. Attorneys want to show value, and simplifying would be out of line with prior precedent. We are therefore probably stuck with a burgeoning world of MAC clauses, with sparse case law to guide us through this morass. This is why the Accredited case was important. The settlement provided guidance to others in the financial crisis as to how parties should assess the validity of a MAC.
In the few cases the Delaware courts have considered a MAC, the courts appear to have set a high burden of proof for buyers. The Delaware courts are on solid ground to set a sizable threshold for finding a MAC. Economically, a buyer can compensate for the specific risk of its target by negotiating an agreement and due diligence, that is, preacquisition investigation of the target.When unexpected events occur, the risk of loss is now just a zero sum game. Will it be allocated to the target’s shareholders or the buyer? By erecting a hard rule in prior and future cases, the Delaware courts ensure that parties who really want to avoid this problem will draft around it. Moreover, this will ensure that the MAC clause is not triggered by systemic risk, risk that cannot be avoided.
By keeping the wording vague, MAC clauses encourage parties to renegotiate and allocate this loss. However, by setting the bar too high, Delaware courts risk upsetting this renegotiation game and the insurance purpose of a MAC by creating too much certainty in a MAC renegotiation. After all, it is the uncertainty of a MAC that creates these options for target and buyer and bonds the parties further in any renegotiation. In further interpreting IBP, Frontier, and Huntsman, the Delaware courts would do well to preserve the opening for a MAC assertion to leave room for renegotiation. Thus, the true impact of these cases will come in later disputes as the standards they set are fleshed out.
Attorneys would do well to simplify MACs, but it will be in the courts where the MAC is actually further defined. Once again, there has been practitioner talk of converting MACs to dollar amounts in light of the Huntsman case. Given the MAC’s traditional role of ensuring a renegotiation, a numerical MAC is not likely to gain widespread adoption. Thus, while lawyers may indeed go against their penchant for complexity, and exclusions may be cut back or vary in language, it will be the courts that continue to flesh out the scope of the MAC. Nonetheless, in light of the financial crisis, there has been one observed change to MAC clauses: Some of these clauses now expressly override the Delaware holding that a MAC must be of a long-term durational nature and contractually include short-term effects. It remains to be seen if the MAC is further affected by drafting changes spurred by the financial crisis.
Regardless of the future of the MAC, by the end of fall 2007, the parameters of a MAC clause dispute had been set and the difficulty of establishing a MAC affirmed. These events would steer the next wave of deal failures, the private equity implosion.
Chapter 4
United Rentals, Cerberus, and the Private Equity Implosion
The unfortunate experiences of Accredited, Radian, and SLM were the first signs of significant disruption in the takeover market. As the credit crisis continued, they would be only three of many failed and renegotiated takeover transactions. At the time, though, these disputes appeared to be unique, a function of the nature of the company’s business, in the case of Radian and Accredited, or the specific bargained-for wording of a MAC clause in the case of SLM. But as the August disruption continued, stock market volatility increased, the credit markets became increasingly illiquid, and the subprime mortgage crisis began to spread generally into the markets and the economy. These events turned public attention to the viability of pending takeover transactions in other industries. The bulk of pending takeovers were sponsored by private equity, the dominant force of that time. As of August 1, 2008, more than $250 billion in pending private equity transactions were awaiting financing and completion.1
A number of public commentators and news sources began to report on the optionality inherent in the private equity acquisition agreement, the reverse termination structure discussed in Chapter 2. Many of these reports questioned the willingness of private equity firms to complete these acquisitions. The first prominent news piece, published in the New York Times on August 21, 2007, was titled “Can Private Equity Firms Get Out of Buyouts?”2 The article, by Andrew Ross Sorkin, highlighted the reverse termination fee structure, detailed the current uncertainties of financing, explored the willingness of private equity buyers to terminate these transactions, and discussed the reputational constraints on the ability of private equity firms to do so.
Sure enough, beginning in August and through mid-November 2007, private equity firms in three pending public transactions with reverse termination fee structures did indeed attempt to terminate acquisitions agreed to prior to the summer credit crisis. These involved the already discussed buy-out of SLM Corporation and two others: the $3 billion buy-out of Acxiom Corporation, the marketing services provider, and the $8 billion buy-out of Harman International, Inc., the legendary audio company, still run by its 89-year-old founder Sidney Harman. In each case, the private equity buyers did not invoke the reverse termination fee provisions negotiated in their transaction agreements. These private equity buyers instead asserted real or ostensible MAC claims to terminate their obligations.
The presence of a reverse termination fee would work to alter the traditional mechanics of the MAC dispute. This was illustrated in both Harman’s and Acxiom’s cases. In each of these deals, the grounds for the MAC assertion were never made clear, at least publicly. But the buyers in each obviously felt that the deal no longer made ec
onomic sense or otherwise could not be financed. These buyers therefore exercised the MAC clauses in their agreements for at least three reasons: First, the deterioration in the markets and general economy provided a colorable basis to make this assertion. In the cases of Acxiom and Harman, there were also specific claims that each company had deteriorated disproportionately to their peers.3 Second, a MAC claim provided reputational cover. Instead of being labeled as walking on their contractual obligations, a MAC claim provided historically legitimate grounds for a buyer to terminate the transaction. It is generally perceived as acceptable for a buyer to invoke a MAC.Third, a MAC claim provided negotiating leverage to the private equity firm. Under the terms of each of these agreements, if the private equity firm was successful in claiming a MAC, it could terminate the agreement without any required payment to the target.
Moreover, the maximum liability of the private equity firms if their MAC claim failed was capped at the reverse termination fee. It would otherwise be zero if a MAC claim could be proved. Thus, any negotiation between the parties would start at the maximum number set by the reverse termination fee and go only down.This last dynamic would affect the incentives of private equity buyers to renegotiate the transaction. As discussed in the preceding chapter, in a traditional MAC dispute, the terms of the acquisition agreement placed pressure on the buyer to renegotiate because the buyer feared losing the dispute and paying a full purchase price for the target. This never became an issue in a private equity agreement with a reverse termination fee. The reverse termination fee served as a significantly reduced cap on the maximum liability of a buyer, approximately 3 percent of the deal value. The negotiation thus revolved around how much of the reverse termination fee the buyer would pay and not on a renegotiation of the transaction.The settlement incentive present in ordinary, strategic transactions was thus markedly lower.
The failed Harman and Acxiom deals proved this point. Both transactions were ultimately terminated through an agreement among the parties. The Acxiom deal was terminated on October 1, and Harman was terminated officially on October 22.The legitimacy of these MAC claims and the effect of the reverse termination fee provision on the settlement were reflected by the amounts the private equity firms ultimately paid to the targets to terminate the transaction. This amount was the parties’ assessment of success in any litigation. This was good proof that the parties did not think that the MAC claims would succeed in litigation, but rather were instead brought to provide reputational cover for these terminations.
In the Acxiom termination, the two buyers, Silver Lake and ValueAct Capital LLC, paid $65 million to terminate the transaction. The Acxiom agreement provided for a two-tiered reverse termination fee. The lower fee of $66.75 million was payable if there was a failure of debt financing; the higher amount of $111.25 million functioned as a maximum cap on the buyers’ liability.4 It was never disclosed why the two buyers’ payment was $1.75 million less than the lower fee. But the fact that the settlement approximated the lower fee probably meant that the lenders on the deal were balking at funding the transaction, providing a basis for the buyers to set their maximum liability at $66.75 million. This was subsequently confirmed by news reports that half of the fee paid to Acxiom was paid by Morgan Stanley and UBS, two of the three banks financing the deal.5
Meanwhile, the amount of the payment in the Harman termination was disguised; KKR and GS Capital Partners, the private equity buyers, elected to buy convertible notes worth $400 million in Harman yielding 1.25 percent per annum and initially convertible at $104 per share. The notes were clearly priced to provide an additional benefit to Harman, and though the benefit was difficult to calculate, the true payment appeared to approximate the reverse termination fee.6
In Federalist Paper Number 15, Alexander Hamilton observed that reputation is a “less active influence” constraining behavior when a nefarious deed is done by many. Hamilton’s observation aptly applies to the events surrounding the fall 2007 wave of private equity acquisition terminations. Initially, no single private equity firm was willing to stain its reputation and harm its competitive position in the buy-out market by invoking a reverse termination fee provision. Instead, in the Acxiom and Harman deals, these firms asserted MAC claims to publicly justify termination and avoid being labeled as walking on their transactions and as an untrustworthy future buyer. However, as the fall progressed, the reputational forces on private equity firms to complete buyouts became diluted as the credit markets remained illiquid and the number of terminated private equity deals increased. The early fall MAC cases like Accredited had also illustrated the high hurdle a buyer had to jump to establish even a colorable MAC claim.These forces would combine to shape the next wave of failed private equity acquisitions.
The Cerberus-United Rentals Dispute
On November 14, 2007, a private equity fund controlled by Cerberus Capital Management LP, the hedge fund and private equity firm, suddenly attempted to terminate its $5 billion agreement to acquire United Rentals Inc., the rental equipment provider. Cerberus did not assert a MAC to justify its action. Cerberus actually went out of its way to note that no MAC had occurred and confirmed this to United Rentals at the time it terminated the agreement.7 Rather, the shell subsidiaries owned by Cerberus who were the parties to this agreement simply invoked the reverse termination provision in the acquisition agreement.8 Cerberus argued that this provision permitted it to terminate its obligations for any reason upon payment of a $100 million reverse termination fee.
Cerberus had decided that any reputational impact was overcome by the declining economic return of the transaction. In assessing the reputational damage, Cerberus was no doubt influenced by the prior failure of private equity transactions in Acxiom, Harman, and SLM and the atmosphere they created, which diminished the reputational impact for simply walking on a transaction. Cerberus itself was also operating under a tarnished halo, as only a few weeks before, it had abruptly terminated preliminary negotiations to buy out Affiliated Computer Services, Inc. This and Cerberus’s status as a nontraditional private equity investor—its roots were as a hedge fund—may have made it only easier for it to spurn United Rentals.
United Rentals sued the Cerberus shell subsidiaries in Delaware Chancery Court, challenging their attempt to terminate the agreement. United Rentals argued that the acquisition contract allowed United Rentals to force the shell subsidiaries to specifically perform their obligations. In other words, the parties’ dispute centered on the type of reverse termination fee structure they had negotiated, the pure reverse termination fee or specific performance structure. United Rentals argued that this contract provided for specific performance of the shell subsidiary entities’ financing commitments (i.e., United Rentals could force the shell subsidiaries to take the actions agreed to in their agreement). Only if the financing then failed could the entities terminate the agreement. The Cerberus shell entities argued that the same language of the contract barred specific performance and that their only liability was for $100 million.9
These were diametrically opposed arguments. Under Cerberus’s argument, it could walk at any time and for any reason, simply by paying $100 million. United Rentals argued that the same acquisition agreement provided United Rentals the right to force Cerberus to complete the acquisition.The problem was that both were arguably right.The contract language was ambiguous and could reasonably be interpreted to support either position.This was remarkable.The contract on the $5.4 billion deal had been negotiated by two top law firms, Simpson Thacher, & Bartlett, LLP and Lowenstein Sandler, PC, yet you could not definitively determine the parties’ rights to terminate it. If you read the language, it did appear that United Rentals had the better argument, but it was not clear-cut by any means. Unlike Acxiom, Harman, and SLM, Cerberus had the real possibility of having to do more than pay a reverse termination fee. They may actually have been required to complete the transaction.10
It would later be rumored that a settlement was not reached because of
Cerberus CEO Stephen Feinberg’s insistence that there be a meaningful reduction of the purchase price and United Rentals refusal to accede to this request.11 The trial was held in Delaware Chancery Court from December 17 to 19.When the notoriously secretive Feinberg testified, the Wall Street Journal blog The Deal Journal ran an image from his testimony under the heading “The Money Shot,” stating that Feinberg was a “faceless tycoon no longer.”12
The lawyers were in a particularly bad position. Both sides’ lawyers had engaged in shorthand contract drafting as they negotiated and had drafted an ambiguous clause on the most important issue: When could Cerberus terminate the transaction? It appeared that one law firm or the other had made a mistake. Although we may never know the true answer, the court decision placed the mistake at Lowenstein’s feet. According to the court’s findings, Eric Swedenburg, the primary negotiating attorney at Simpson for United Rentals, had recognized the error and remained quiet, preferring to leave an ambiguous agreement rather than a fully negotiated one that was adverse to his client. Swedenburg, apparently with the blessing of his client, had appeared to come to the conclusion that raising the issue again would only have led to his side losing the argument. Leaving it ambiguous preserved a litigation position and an ability to challenge the termination in court, a situation the parties were in right now.13
Chancellor William B. Chandler, the judge in the Chancery Court, found that the contract language was indeed ambiguous. He then applied the principle of the “forthright negotiator” to find that Swedenburg knew that the contract was meant to be negotiated as a pure reverse termination fee deal and failed to disclose the drafting error. Under the “forthright negotiator” doctrine, Swedenburg should have disclosed this mistake, and the contract should be read as Cerberus intended. Chandler had applied standard contract interpretation principles to hold in favor of Cerberus’s reading of the agreement.14 When United Rentals announced that it would not appeal this decision, Cerberus promptly terminated the acquisition agreement and paid United Rentals $100 million.15