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

by Steven M. Davidoff

  The fears about Clear Channel’s main deal turned out to be right. But things unfolded in a much different manner than anticipated. Instead, Bain Capital and Thomas H. Lee (THL), Clear Channel’s buyers, came out fighting to complete the acquisition. On March 26, 2008, 12 days after resolution of the first Clear Channel litigation, Bain Capital and THL sued their financing banks in New York Supreme Court.32 In their complaint, the private equity firms alleged that the banks had breached their commitment letters by demanding unreasonable terms that were onerous and unusual. The banks made these demands in an attempt to terminate their obligations under the commitment letter, something the banks were incentivized to do in light of their possible $2.65 billion loss.

  The private equity firms asserted that the language proposed by the banks violated the requirement in the debt commitment letter that the final debt “contain the terms and conditions set forth in this Commitment Letter and shall be customary for affiliates of the Sponsors.”33 This “sponsor precedent” clause was considered quite friendly to the private equity firms because it narrowed the scope of precedent to be referenced to that in which the sponsor, another name for the private equity firm, had previously agreed to.

  This was a different scenario than what unfolded in the Clear Channel TV station litigation. Here, it appeared that the private equity firms wanted to complete the transaction.They were, after all, suing. But the Clear Channel main agreement contained a $500 million reverse termination fee.The private equity firms could walk at any time simply by paying this fee.34 Given that the private equity firms stood to lose probably more than $500 million if the deal went through on its current terms, people questioned the motives of the private equity firms’ suit as a renegotiation ploy. The private equity firms could appear to publicly be the good guys while privately pressuring Clear Channel to settle. In a worst case scenario, the private equity firms would lose the litigation but could still walk from the transaction by paying the fee. But Clear Channel knew the private equity firm’s options, so they would be likely to work with the private equity firms to settle the dispute with the banks by reducing the price the private equity firms paid. Still, to the credit of THL and Bain Capital, there was no doubt that the private equity firms were litigating. Scott Sperling, managing director of THL, even went on CNBC to tell TV reporter Erin Burnett why THL was fighting this battle and to proclaim his firm’s commitment to acquiring Clear Channel.

  The banks countered that the 71-page debt commitment letter they had issued to THL and Bain Capital was unenforceable because it contained too many open, yet to be negotiated terms. It was an agreement to agree, unenforceable under the laws of New York. Only with final documentation would the contract be sufficiently complete to be enforceable. In addition, the banks argued that a specific performance remedy was unavailable to the private equity firms; they were limited to money damages because specific performance could be awarded only when money damages were an inadequate remedy that could not be calculated. Here, the damages were easily calculable as the cost of finding alternative financing.35

  However, the banks also argued a catch-22 for THL and Bain Capital. The banks claimed that specific performance was unavailable but then asserted that money damages would also be unavailable under the terms of the debt commitment letter.The reason was that the letter barred monetary damages. In any event, the banks also asserted that the acquisition agreement limited the private equity firms’ monetary damages to $500 million, the amount of the reverse termination fee. Finally, the banks argued that the sponsor precedent language cited by the private equity firms was essentially meaningless since, due to the state of the market, no transaction was customary or similar.36

  The dispute entered into discovery with the parties making the same arguments. Some of the banks’ arguments appeared strained. In particular, the inclusion of sponsor precedent language seemed to nullify their argument that these were simply unenforceable agreements to agree. The sponsor precedent language provided a road map to document the final terms. And these letters had been standard in acquisitions for almost three decades—at no time before had a party asserted they were unenforceable. Despite the apparent weakness of the banks’ case, there was substantial risk that the entire deal could blow up.

  Settlement negotiations were hampered by anger; as one person put it: “The companies and lenders were hating each other so intensely that if it were in person, we would have needed an armed guard.”37 However, the risks were too great, and the parties “had to wipe away the emotional issues and come to a pain-sharing agreement.”38 An initial meeting at a hangar in a Westchester airport was arranged, and from there on the eve of trial on May 13, 2008, the deal was renegotiated. They indeed did share the pain. Clear Channel agreed to a lower price, and the private equity firms agreed to an increase in their equity commitment and the interest rate they were to pay on their bank debt and a decrease in the amount of debt financing provided by the banks. The transaction closed on July 30, 2008.39 Nonetheless, the banks were proven right in their resistance; by December 2008, some of Clear Channel’s debt was trading at less than 20 cents on the dollar.

  At this point, it was clear that there had been a wholesale breakdown in the mechanics of private equity transactions. First, the structure of the deal between private equity and its targets was a fragile one. The pure form of these deals—those with a reverse termination fee and a bar on specific performance—allowed a buyer to walk for any reason now with little reputational constraint. The second form of this deal, the specific performance version litigated in the ADS and Clear Channel TV station litigations, was quite difficult to enforce. It required a target to sue the buyer and then potentially force the buyer to sue the lender, creating two different suits in two different jurisdictions. This was even before the fund itself decided whether to renege on creating a third suit. Moreover, banks were now disputing the enforceability of their debt commitment letters. This was shocking. In their struggle to escape from these bad loans, the banks were arguing that their agreements meant nothing. In taking such extreme actions, the banks were showing not only their dominance in their relationship with private equity, but their willingness to take reputational and relationship hits in pursuit of their own economic interests.

  In the wake of the collapse of the ADS transaction and the renegotiation of Clear Channel, the market stood on edge waiting for what would happen to the Penn National and Huntsman buyouts. It was not a happy ending for either. The end to the $8.4 billion Penn National buy-out came rather quickly in July 2008. Penn National, a gaming company, was thought to have a very tight acquisition agreement. It was of the specific performance variety and included an unusual right for Penn National to directly sue Fortress to force it to perform its obligations under its equity commitment letter.40

  The settlement came in the form of a discounted preferred stock investment by Fortress in the amount of $1.25 billion and a payment of the reverse termination fee of $225 million. It was clearly valued above the $225 million reverse termination fee set forth in the acquisition agreement but left Penn National trading at $28 per share, well below Fortress’s initial offer price of $67 per share. When announcing the settlement, Penn National’s management emphasized that the prospect of litigation against Fortress and the banks forced them into settling. Penn National CEO Peter M. Carlino stated, “This transaction represents the Company’s best alternative to the uncertainty of litigation.”41 Targets had lost confidence in the enforceability of their agreements.

  The Huntsman and Hexion result was even worse. As discussed in Chapter 3, on June 18, 2008, Hexion had sued Huntsman, claiming that it was permitted to terminate their $10 billion deal on account of the occurrence of a MAC to Huntsman and the insolvency of the combined entity. It was a daring litigation strategy for Hexion, as the insolvency claim blew up its own financing arrangements and, if Hexion’s claim failed, was likely to leave it without the money to acquire Huntsman. Huntsman responded forcefully against the cla
ims and countersued Apollo and its key executives Leon Black and Joshua Harris, as well as Credit Suisse and Deutsche Bank, the two banks financing the acquisition, in Texas state court, claiming tortious interference of contract, namely the agreement between Huntsman and Hexion. Huntsman also claimed that these companies and individuals had tortiously interfered with Huntsman’s contract to be acquired by the Dutch chemical company Basell Industries AF. Huntsman had spurned that bid on July 12, 2007, and an extra $2.75 a share to be acquired by Hexion, a decision on the eve of the subprime crisis that at the time was appropriate but in hindsight seemed particularly regretful.

  Huntsman was attempting to invoke the demons of the seminal case of Pennzoil v.Texaco In that case, Pennzoil Co. had an alleged informal, binding contract with Getty Oil Co. to purchase the company. Texaco, Inc. intervened with its own proposal, and in a San Antonio court, Pennzoil won a $10.53 billion jury verdict against Texaco on a tortious interference claim. Texaco was forced to declare bankruptcy and eventually paid a lower negotiated amount of $3 billion.42 With its claim of tortious interference of contract, Huntsman was putting the pressure of a possible Texas-size jury verdict on Apollo and the banks.

  The Texas case, though, was a stretch legally, and at the time commentators speculated that a renegotiation of the price was the most economical route for both parties. The parties did not settle, and the trial began on September 8, 2008. Jon Huntsman on the eve of trial spoke to the Wall Street Journal personally, attacking the head of Apollo, Leon Black, for reneging on his word. This was probably why no settlement was forthcoming at the time.The Huntsmans were simply still too angry over Leon Black and Apollo’s conduct. Jon Huntsman would state:

  I will fight this until the day I die… . Private-equity firms have taken over America, and we will fight it. These guys are getting away with dishonest behavior, and I won’t tolerate it.43

  Vice Chancellor Lamb provided the Huntsmans some solace when he ruled forcefully against Hexion. He denied the MAC claim and found that the agreement with Huntsman did not provide a financing out for Hexion, nor did it contain a reverse termination fee provision. He did not therefore need to determine at that time whether the combined entity would be insolvent. He found Hexion in breach of the agreement, leaving Hexion in a bad position.44 Hexion was now facing a damages claim that it could not pay and banks who could rely on Hexion’s own allegations to refuse to fund the transaction. Huntsman had shown how the strength of an agreement could make a difference. Their lawyers at Shearman & Sterling and Vinson & Elkins LLP had negotiated a nontraditional private equity agreement that looked more like a strategic one. The result was to provide Huntsman a successful litigation position.

  Hexion had initiated a very aggressive litigation strategy that appeared to be backfiring. On October 29, it was forced to sue its financing banks, who indeed now refused to fund the acquisition based on Hexion’s own insolvency claims. Nonetheless, a month and a half later on December 14, 2008, Hexion and Huntsman announced a settlement with Apollo and Hexion. The headline figure for the settlement was $1 billion, but it was actually lower, as it included $250 million in 10-year convertible notes that would have to be repaid.45 In the wake of the settlement, Huntsman’s market capitalization fell to approximately $700 million, meaning the market assigned almost no value to the Huntsman business itself. Notably, Huntsman did not at this time settle its suit against the two banks—this would come later in June 2009. At that time Huntsman settled with Credit Suisse and Deutsche Bank for $632 million in cash and $1.1 billion in subsidized financing.

  The settlement with Hexion was a surprise as it appeared to be in an amount below the Penn settlement, despite Huntsman having a more favorable agreement and litigation position. The rumor was that Huntsman was forced to the table by its own liquidity problems. It no longer had the funds to survive to pursue litigation. Moreover, given its shaky claims against Apollo, Huntsman would be forced to seek a remedy from Hexion, rendering Hexion insolvent and providing Huntsman with little monetary compensation. This theory was later provided support when Huntsman obtained a similar recovery against the less culpable banks in June 2009, a time when Huntsman was much more stable.

  It would also be later disclosed that Jon Huntsman, the man who had vowed to “fight this until the day I die,” was paid $15 million by Huntsman for negotiating the settlement. The payment raised a conflict of interest issue: Was it appropriate for Huntsman to pay this fee to a large shareholder who already had a significant incentive to negotiate on behalf of Huntsman? In defense of Jon Huntsman, Nolan Archibald, a director of Huntsman, has asserted that the payment was quite justified and was for “singlehandedly negotiate[ing] this settlement” and “sav[ing] the company in doing so.”46

  Apollo and Hexion had succeeded in their gambit, but this entire episode tarnished Apollo’s reputation as well as that of Joshua Harris and Leon Black, its executives. Apollo’s investors no doubt also sweated the prospect of a Hexion bankruptcy and significant damages. In Apollo’s case, it had adopted a litigation strategy that was quite risky and ultimately succeeded only by luck. Many questioned whether they would have been better off from the start simply waiting for the inevitable bank suit to provide them a cleaner motive for attempting to escape the transaction. But this was more speculation, and presumably Apollo took on this risk knowingly.

  Huntsman’s board appeared particularly dumbstruck.The deal will be cited for years in this more troubled age for the principle of taking a more certain deal as opposed to a higher bid with financing risk. In the end, Huntsman’s board spurned a bid by another suitor, Basell, for a few extra dollars a share, leaving Huntsman with little. Of course, the Huntsman board made this decision in much better times and without foreknowledge of the financial crisis, but it still was a sobering, going-forward lesson on the risks of delay in an acquisition during times of financial crisis rather than the sunnier times of July 2007 when such delay meant little.

  The final death song of the private equity era was BCE Inc., the Canadian telecommunications giant.The BCE buy-out, the largest private equity buy-out ever agreed to, went through twist and turn. It was almost felled by an adverse decision in bondholder litigation; then it was resurrected by a reversal of that ruling by the Canadian Supreme Court.47 It was renegotiated in July and appeared on track toward a December closing. Then, a few weeks before the closing, BCE’s hand-picked accountant, KPMG, asserted that it could not provide the solvency opinion required under the acquisition agreement. KPMG’s refusal to issue the solvency opinion allowed its buyers to refuse to complete the transaction. This they did, and the deal was terminated on December 11. The parties are still litigating whether the buyers are required to pay a $C1.2 billion reverse termination fee.48

  Fault and the Failure of Private Equity

  Who is to blame? The refrain has been repeated throughout the failure of many of these deals, as targets, private equity firms, investment bankers, banks, and lawyers were variously censured for the serial implosion of so many private equity transactions. Here, criticism of the private equity structure was principally directed at the optionality and the resulting uncertainty it created. In its purest form, the reverse termination fee structure created an option. The private equity firm had the discretion to exercise this option, and if the firm did so, it could terminate the transaction and pay the reverse termination fee. A private equity buyer could thus assess the benefits of the transaction before completion and decide whether it was more economical to complete the transaction. Otherwise, the firm could pay the reverse termination fee and terminate the acquisition agreement.

  This option was not calculated according to any option pricing method. Nor did it appear to be calculated by reference to the damage incurred by a target in the event it was exercised by the private equity firm.The amount ultimately paid also did not deter buyers from exercising it in many instances. Rather, the amount of the reverse termination fee was set normatively by reference to the termination fee typica
lly paid by targets, approximately 3 percent of the transaction value. Setting the fee at 3 percent for buyer and target made for a symmetrical penalty.

  But this type of penalty was completely different. The termination fee was capped by Delaware case law and was designed to deter competing bids and compensate bidders for the costs associated with making a trumped offer.The same principles did not apply in the reverse termination fee context.The fee in a number of prominent instances did not deter exercise of the option, and in hindsight, the amount appeared to undercompensate targets for the losses incurred by the target company and its shareholders. Evidence of this came from the posttermination share trading prices of targets against whom these provisions were invoked. In the months after the exercise of this provision, the share prices of these companies traded significantly below the preoffer price.49

  So why did targets and their advisers agree to this type of provisions? Here is what probably happened:

  First, the reverse termination fee structure provided more closing certainty than the structure it supplanted. In the pre-2005 structure described in Chapter 2, the structure was wholly optional. The target entered into an agreement with thinly capitalized shell subsidiaries, and the agreement itself contained a financing condition. If the subsidiaries refused to perform or financing failed, the target was left with no compensation or recourse to the private equity firms except through a veil piercing or other creative litigation argument.

  Second, reputation mattered. Private equity was a multiplayer game. It was assumed that the reputational incentive to close would keep them from exercising the reverse termination fee option and being perceived as reneging on their deals. The penalty for failure to follow this norm would be a higher price paid in future transactions to compensate targets for this failure and increased risk, as well as any other public approbation for this action.