Last week, the Delaware Court of Chancery rejected the efforts of Hexion Specialty Chemicals Inc. and its affiliates ("Hexion") to avoid consummating a $10.6 billion leveraged cash acquisition by merger of Huntsman Corp. ("Huntsman"). In its ruling, the Court granted Huntsman the remedy of specific performance, ordering Hexion to comply with the terms of the merger agreement (other than the ultimate obligation to consummate the merger).
In July 2007, Hexion, a subsidiary of the private equity firm Apollo Management LP, entered into a merger agreement with Huntsman in which it agreed to acquire Huntsman for approximately $10.6 billion. The merger agreement was the result of a bidding war in which Hexion topped the price that another bidder had agreed to pay in a merger agreement that Huntsman had previously executed with that other party. Although Hexion's obligations under the merger agreement were not conditioned upon Hexion obtaining financing for the acquisition, the merger agreement obligated Hexion to use is "commercially reasonable efforts" to take all actions and do all things "necessary, proper or advisable" to consummate the financing on the terms it had negotiated with the banks and not to take any action "that could reasonably be expected to materially impair, delay or prevent consummation" of the financing. The merger agreement also contained a standard condition that Hexion's obligations were conditioned on Huntsman not experiencing a "material adverse effect" ("MAE") from the date of the merger agreement through the closing date. In addition, the agreement provided that Hexion could terminate the agreement and pay a $325 million termination fee; provided that Hexion had otherwise complied with the merger agreement. The merger agreement specifically provided that if the buyer had "knowingly and intentionally" breached its covenants, Hexion's liability to Huntsman would not be subject to that liability cap.
During the Spring of 2008, Huntsman reported disappointing financial results for the first fiscal quarter. Following the release of those results, Apollo met with its legal and financial counsel to analyze the results and revise its financial models for Huntsman and the combined companies. On June 18, Duff & Phelps delivered an opinion to the Hexion board of directors to the effect that the combined Hexion/Huntsman company would be insolvent following consummation of the merger. After obtaining the insolvency opinion Hexion filed suit in Delaware. In September, following extension by Huntsman of the termination date of the merger agreement, the Delaware Court of Chancery held a six-day trial.
Hexion argued that the failure of Huntsman to meet its projected quarterly targets constituted an MAE for purposes of the merger agreement, thereby excusing Hexion from completing the transaction. In its lawsuit, Hexion sought a declaratory judgment that, among other things, (i) it was not obligated to consummate the merger if the combined company would be insolvent, and its (and Apollo's) liability to Huntsman for failing to close the transaction could not exceed the $325 million termination fee, (ii) Huntsman had suffered an MAE, and, therefore, Hexion was not obligated to consummate the merger, and (iii) Apollo had no liability to Huntsman in connection with the merger agreement.
Huntsman counterclaimed that (i) Hexion knowingly and intentionally breached the merger agreement, (ii) Huntsman had not suffered an MAE, and (iii) Hexion had no right to terminate the agreement. Huntsman sought an order directing Hexion to specifically perform its obligations under the merger agreement or, alternatively, to pay full contract damages to Huntsman, potentially in excess of the $325 million termination fee.
In his decision, Vice Chancellor Lamb found that Huntsman had not suffered an MAE, and that Hexion had "knowingly and intentionally" breached a number of its covenants under the merger agreement, including the covenants regarding the financing. Consequently, the Court granted Huntsman's request for specific performance, and ordered Hexion to perform all of its covenants and obligations under the agreement (with the exception of the ultimate obligation to close because the merger agreement expressly provided that the remedy of specific performance was not available with respect to that obligation).
The Court's consideration of the major contentions of the parties are discussed below.
The MAE Clause
In a decision consistent with other cases in which the Delaware courts have examined "material adverse effect" or "material adverse change" clauses, the Court rejected Hexion's argument that Huntsman had experienced an MAE. Vice Chancellor Lamb remarked that it was no coincidence that Delaware courts have never found a material adverse effect to have occurred within the context of a merger agreement. In the absence of clear language to the contrary, the Court found that the burden of proof rests on the party invoking the MAE clause and seeking to excuse its performance under the contract. The Court noted that, in examining an MAE clause, the important question is "whether there has been an adverse change in a target's business that is consequential to the company's long term earnings over a commercially reasonable period" (i.e., years rather than months). In other words, as the Delaware Chancery Court had previously noted in another case, "a short-term hiccup in earnings should not suffice; rather [an adverse change] should be material when viewed from the longer-term perspective of a reasonable acquirer." In analyzing the decline in earnings, the Court stated "for such a decline to constitute a material adverse effect, poor earning results must be expected to persist significantly into the future." The Court also concluded that EBITDA is a better measure than earnings per share of a business's operational results, particularly in the context of a cash acquisition, such as the proposed Huntsman/Hexion transaction. In reaching this conclusion, Vice Chancellor Lamb noted that unlike earnings per share, EBITDA is independent of a company's capital structure and is a better gauge of a company's operational performance.
Hexion based its claim that an MAE had occurred (and, therefore, that it was excused from consummating the merger and paying the $325 million termination fee) on three factors: (i) disappointing results in earnings since signing the merger agreement relative to management's projections, (ii) an increase in net debt contrary to expectations, and (iii) underperformance of two of Huntsman's divisions. The Court rejected all three arguments; in reaching its conclusions, the Court found:
- Huntsman's "failure to hit its forecasts cannot be a predicate to the determination of an MAE in Huntsman's business", given that the merger agreement specifically excluded projections, forecasts and estimates from Huntsman's representations and warranties, and allocated to Hexion the risk that Huntsman's performance would not live up to management's expectations at the time. Hexion had, therefore, failed to demonstrate the existence of an MAE in order to negate its obligation to close;
- Because Hexion's original financial models which considered Huntsman's projected reduction in net debt to be not more then "an added attraction". Accordingly, Hexion could not now claim that even a 5% increase in net debt as against expectations should excuse its obligation to perform; and
- the merger agreement required an MAE to be determined based on an examination of Huntsman as a whole, and not an examination of selected divisions "only tangentially related to the issue." The Court was also satisfied that the underperformance was "short-term" in nature, and that Apollo was aware of the cyclical nature of one of the divisions' business.
Defining "Reasonable Best Efforts; Hexion's Knowing and Intentional Failure to Use Reasonable Best Efforts to Consummate the Financing and Failure to Give Huntsman Notice of its Concerns
Both parties sought declaratory judgments as to whether Hexion had committed a "knowing and intentional" breach of the merger agreement. Hexion argued that no "knowing and intentional" breach had occurred, and, therefore, its liability for any breach of the merger agreement should be capped at the $325 million termination fee. Huntsman sought a judgment that Hexion had "knowingly and intentionally breached" the merger agreement, thereby entitling Huntsman to full unliquidated contract damages.
After reviewing the parties' interpretation of the phrase "knowing and intentional", the Court defined it to mean "the taking of a deliberate act, which act constitutes in and of itself a breach of the merger agreement, even if breaching was not the conscious object of the act." Based on this definition, the Court held that Hexion had committed a "knowing and intentional" breach because it had failed to use its reasonable best efforts to consummate the financing. The merger agreement required Hexion "to take any an act that was both commercially reasonable and advisable to enhance the likelihood of consummation of the financing", and to notify Huntsman if it no longer believed in good faith it would be able to draw upon the commitment letter financing. Vice Chancellor Lamb found that Hexion deliberately failed to act, and that Hexion pursued another path (obtaining the insolvency opinion) designed to avoid the consummation of the financing. Therefore, the Court concluded Hexion had knowingly and intentionally breached the covenant.
Hexion's conduct also breached its covenant not to take any action "that could be reasonably be expected to materially impair, delay or prevent consummation" of such financing. In reaching this conclusion, the Court disapproved of what it considered to be Hexion's carefully designed "plan to (i) obtain an insolvency opinion, (ii) publish such opinion in a press release (which it knew, or reasonably should have known, would frustrate the financing), and (iii) claim it did not 'knowingly and intentionally' breach its contractual obligations to close (due to the impossibility of obtaining financing without a solvency certificate)". The Court also specifically discredited the insolvency opinion as unreliable, given Hexion's (and Apollo's) attempt to use the purported insolvency of the combined company as an excuse to avoid Hexion's obligations under the contract. This, combined with Hexion's lack of effort and failure to attempt to confer with Huntsman when Hexion first became concerned with the potential issue of insolvency and failure to use reasonable best efforts to obtain antitrust clearance, led the Court to conclude that Hexion had committed a "knowing and intentional" failure to use reasonable best efforts to consummate the merger and had exhibited a lack of good faith. This in turn rendered the liquidated damages clause inapplicable and entitled Huntsman to specific performance and, ultimately, to uncapped damages for breach of contract.
Potential Insolvency of the Merged Company
The Court declined to rule on whether the combined entity, however capitalized, would be solvent at closing. Instead, the Court instructed Hexion to explore the many available options for mitigating the risk of prospective insolvency while performing its contractual obligations in good faith. If, at closing, and despite Hexion's efforts, financing had not been available, Hexion could then have stood on its contract rights and faced no more than the contractually stipulated damages.
Specific Performance Remedy
The Court ruled that Huntsman was entitled to judgment, ordering Hexion to specifically perform its covenants and obligations, other than the ultimate obligation to consummate the merger (the merger agreement explicitly provided that Huntsman was not entitled to specifically perform the obligation to consummate the merger). The Court noted that if all the conditions precedent to closing are met, Hexion will remain free to chose to refuse to close. If it chooses that course, Hexion will be liable to Huntsman for full, uncapped damages.
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