Canada: Leveraged Buyouts Gone Bust

Copyright 2008, Blake, Cassels & Graydon LLP

Originally published in Blakes Bulletin on Mergers & Acquisitions, June 2008

Since the onset of credit tightening last summer, the pace of North American leveraged buyout activity has dramatically slowed and a number of large LBOs have been put on hold or terminated. According to global buyout figures released by Dealogic, while strategic acquisition activity has fallen 24% from last year, sponsor-led buyouts have dropped 74%, with announced transactions under US$1-billion down 39% and deals over US$1-billion down 72%. While the disruption of the credit markets appears to have been an underlying cause of many of the failed LBOs, other issues such as regulatory changes, adverse economic conditions and litigation have also been factors. The issues facing the LBO market have contributed to a substantial decline in the number of deals but have also provided a remarkably insightful period for deal lawyers. The following highlights some of the LBOs that have experienced the most noteworthy difficulties over the past year. While this bulletin primarily addresses U.S. transactions, the lessons learned are likely to influence deal dynamics internationally.


The current LBO market troubles have been most recently exemplified in the highest profile Canadian private equity transaction in history, the C$51.7-billion agreement to acquire BCE Inc. by Ontario Teachers' Pension Plan, Providence Equity Partners and Madison Dearborn Partners. From announcement, BCE bondholders contested the transaction on the basis it was unfair to them as a significant amount of leverage would be added to the BCE balance sheet without any premium being paid to the bondholders (the bond indentures do not provide for a change of control make-whole payment). On June 20, the Supreme Court of Canada ruled in favour of BCE and overturned the earlier Québec Court of Appeal judgment in favour of the bondholders, clearing the way for the transaction to proceed. While the Supreme Court's reasons have not yet been released, the case may provide new guidance to Canadian boards of directors on the factors they should consider in evaluating a change of control transaction. At issue was whether the 'Revlon' duty (the Delaware duty to maximize shareholder value in a change of control context where cash consideration is offered) is the law in Canada or whether boards have an obligation to consider a transaction's impact on other corporate stakeholders.


In May 2008, Bain Capital Partners and Thomas H. Lee Partners settled their litigation commenced against the lenders in the proposed acquisition by the sponsors of Clear Channel Communications Inc., an international radio and communications company. The settlement of the lawsuits, which had alleged breach of contract, fraud, unfair and deceptive trade practices and civil conspiracy, was made in conjunction with an agreed decrease in the purchase price for Clear Channel from US$18.7-billion to US$17.9-billion. In refusing to lend to the sponsors on the original terms of the deal, the lenders had argued that their commitment letters (letters of intent setting out the terms and conditions of longer form credit facilities) were sufficiently imprecise as to be unenforceable. Irrespective, the banks argued they would not be liable for any damages as a result of the sponsors' inability to line up alternative financing due to the bar on "special damages" in the commitment letter's indemnification provisions. This will undoubtedly lead deal lawyers to seek greater precision and certainty in future commitment letters, including a focus on any limits imposed by indemnity provisions.

This settlement has generally been viewed as a positive development for the LBO market (and the BCE deal, in particular, as a number of the Clear Channel lenders are in the BCE syndicate), perhaps providing hope that, despite the current market conditions, troubled deals may proceed on re-negotiated terms.


The largest of the broken LBO deals over the last year was the US$25-billion buyout of Sallie Mae, an education lending company, by JC Flowers & Co., Friedman Fleisher & Lowe, J.P. Morgan and Bank of America. In the view of the sponsors, the business was harmed in July 2007 upon the introduction of U.S. legislation that reduced subsidies to student lenders. JC Flowers claimed that Sallie Mae had suffered a material adverse change to its business and attempted to terminate the merger agreement. Sallie Mae promptly sued JC Flowers for the $900-million reverse break fee payable pursuant to the merger agreement (payable upon failure to close by JC Flowers unless a closing condition, such as the business suffering a material adverse change, was not met). At issue in this case was the scope of the meaning of "disproportional" in a MAC exclusion for changes in laws related to the student lending industry – the change in law had to be disproportional to Sallie Mae to constitute a material adverse change. Notwithstanding the lack of court guidance in this case (it is also worth noting that there is no meaningful Canadian court guidance on the interpretation of MAC clauses generally), deal lawyers will likely seek greater precision in future MAC clauses, including careful consideration of the events that do not constitute a MAC.

On January 28, 2008, Sallie Mae dropped its lawsuit in exchange for a deal to restructure its US$30-billion lending facility with J.P. Morgan and Bank of America.


The US$6.6-billion acquisition of United Rentals Inc., a construction rental company, by Cerberus Capital Management, became mired in litigation after Cerberus argued in November 2007 that the merger agreement allowed it to terminate the deal for any reason as long as it paid the US$100-million reverse break fee specified in the merger agreement. The dispute brought considerable focus to the connection among sponsor limited guarantees, reverse break fees and specific performance provisions, with many arguing that boards had not properly understood the impact on their remedies in the event of a breach of contract. The availability of specific performance, an equitable remedy of the court intended to address situations where damages cannot remediate harm, is also uncertain in a cash transaction where cash damages should in theory be adequate to remediate loss. URI sued Cerberus for specific performance arguing that Cerberus could not walk away and pay the fee without a breach of the merger agreement by URI triggering Cerberus' right to terminate the agreement.

The Delaware Court of Chancery ruled in Cerberus' favour, stating that its position accurately reflected the negotiated agreement. Interestingly for deal lawyers, the Chancellor held that the language of the merger agreement presented a direct conflict between two remedies (the specific performance and break fee provisions), rendering the agreement sufficiently ambiguous as to permit extrinsic evidence on the drafters' intentions to be admitted. Unfortunately (but not surprisingly), the extrinsic evidence of the negotiation process, though ultimately not conclusive, was too muddled to find that URI's interpretation of the agreement represented the common understanding of the parties. Finally, under a Delaware concept called the forthright negotiator principle, the subjective understanding of one party to a contract may bind the other party when the other party knows or has reason to know of that understanding. Because, according to the Chancellor, the evidence in the case showed that Cerberus understood the agreement to preclude the remedy of specific performance and that URI knew or should have known of the understanding, the Chancellor concluded that URI had failed to meet its burden and found in favour of Cerberus.

Rather than appeal the decision, URI agreed to terminate the merger and received payment of the reverse break fee.


The US$8-billion acquisition of car stereo manufacturer Harman International Industries by Kohlberg Kravis Roberts & Co. and Goldman Sachs Capital Partners ran into difficulties in September 2007 when KKR alleged that Harman had suffered a material adverse change in its business. It later emerged that Harman had failed to comply with its capital expenditures negative covenant, materially weakening its hand in enforcing a closing of the transaction. Deal lawyers will consequently focus on the importance of ensuring that target companies abide by agreed upon interim period covenants in carrying on their business.

KKR and Goldman ultimately agreed to a settlement with Harman in October 2007 whereby the sponsors invested $400-million in Harman convertible debt and received a seat on Harman's board of directors.


In April 2008, the Blackstone Group terminated its US$6.4-billion acquisition of Alliance Data Systems Corporation, a credit-card processing services company. Difficulties for the deal emerged in January of this year when the U.S. Office of the Comptroller of the Currency (OCC) required that Blackstone provide a US$400-million guarantee for the liabilities of Alliance Data's credit card subsidiary as a condition of its approval of the transaction. The negotiations among Blackstone and the OCC subsequently broke down and Blackstone notified Alliance Data that it would likely not be able to obtain regulatory approval for the deal despite its reasonable best efforts. Alliance Data has since filed a lawsuit alleging that it is owed a $170-million break fee pursuant to the merger agreement. At issue will be whether Blackstone, in fact, complied with its reasonable best efforts covenant to obtain regulatory approval and close the transaction. Deal lawyers will again consider whether the phrase "reasonable best efforts" provides either party to a transaction with sufficient certainty as to what needs to be done to comply with a contractual commitment.


Regulatory concerns also caused issues for the US$2.2-billion buyout of networking solutions provider 3Com Corp. by Bain Capital and its Chinese partner, Huawai Technologies. In February 2007, the Committee on Foreign Investment in the United States (CFIUS), the national security panel tasked with reviewing foreign investments in the United States, indicated that it would not approve the transaction as originally structured due to the possible transfer of sensitive intrusion prevention technology to China as a result of Huawai's participation. In March 2008, Bain terminated the merger agreement stating it was unable to agree upon an alternative transaction with CFIUS. 3Com dropped a lawsuit filed against Bain and Huawai alleging that it was owed a US$66-million termination fee pursuant to the merger agreement.


The US$1.1-billion buyout of Reddy Ice Holdings, a packaged ice company, by GSO Capital Partners LP was terminated in January 2008 after Morgan Stanley threatened to pull its financing for the deal due to worsening credit markets. Morgan Stanley alleged that it had a contractual right to do so because GSO Capital attempted to change certain deal terms without their consent. The parties subsequently announced that they had entered into a settlement agreement pursuant to which Reddy Ice would be paid a US$21-million termination fee and Reddy Ice agreed to reimburse GSO Capital for up to US$4-million of fees incurred in connection with the deal. This exchange of termination fees for deal expenses negotiated outside the purview of the merger agreement has also been prevalent in other broken deals, such as PHH Corp. and Acxiom Corp. (described below), apparently on the basis that the parties avoided protracted litigation over whether a material adverse change to the business had actually occurred.


The US$1.8-billion acquisition of PHH Corp., the fleet management and residential mortgage provider, by General Electric Capital Corp. and the Blackstone Group was mutually terminated in January 2008. Due to market conditions, JP Morgan Chase and Lehman Brothers Inc. announced a US$750-million reduction of their financing to Blackstone after stating that they had "revised" their interpretation of the funding commitment. Blackstone subsequently negotiated a deal with PHH whereby it paid a US$50-million termination fee to PHH in exchange for reimbursement of US$4.5-million of Blackstone's advisor fees. The parties also agreed that they would share equally in any amounts recovered from Blackstone's lenders in excess of US$30-million.


In October 2007, the US$3-billion acquisition of Acxiom Corp., a database management firm, by ValueAct Capital and Silver Lake Partners, was terminated by the sponsors. Neither party disclosed reasons for the termination. Pursuant to a settlement agreement reached among the parties, Acxiom received US$65-million (less than the US$110-million termination fee set out in the merger agreement), US$30-million of which was paid by ValueAct and Silver Lake and the remainder by two of the lenders in the banking syndicate, Morgan Stanley and UBS AG.


Although no deal lawyer would wish to endure a period of downturn in the M&A market, the current environment has demonstrated that the truest test of contract drafting comes when deals go bad. The lessons learned in 2008 will undoubtedly continue to reverberate in the deal community as the pace of activity picks up in the future.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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