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In a decision that amplifies how Delaware courts analyze material adverse effect clauses
in merger agreements and examines what constitutes bad faith by a buyer, the Delaware
Court of Chancery in Hexion Specialty Chemicals, Inc. v. Huntsman Corp., C.A. No.
3841-VCL, 2008 WL 4457544 (Del. Ch. Sept. 29, 2008), dealt the buyer, Hexion
Specialty Chemicals, Inc., a stunning blow. The court found that the seller, chemical
company Huntsman Corporation, had not experienced a material adverse effect that
excused Hexion's performance of a merger agreement and that Hexion had knowingly
and intentionally breached the agreement. Although the court did not order specific
performance of Hexion's obligation to actually consummate the merger, it required
Hexion to specifically perform its covenants related to financing and antitrust
compliance and ruled that, if Hexion should fail to close, Huntsman's potential damages
would not be limited to the break-up fee.
Hexion Wins Bidding Contest, Then Seeks to Avoid Its Contract Obligations
The case grew out of the successful bid by Hexion, a portfolio company of Apollo
Global Management, LLC, a private equity investor to buy Huntsman in July 2007. To
induce Huntsman to terminate an announced transaction with another buyer, Hexion not
only offered a better price in a cash merger, but agreed to seller-favorable terms,
including a narrowly tailored material adverse effect clause, no financing out, an
obligation to use its reasonable best efforts to obtain the financing, a "hell or high
water" antitrust compliance provision and the possibility of essentially uncapped
damages if the transaction should fail to close as a result of Hexion's knowing and
intentional breach.
Vice Chancellor Lamb carefully reviewed Hexion's performance in relation to the terms
of the merger agreement and found for Huntsman on nearly all claims.
This Update provides key highlights of the Hexion decision and offers practical advice.
In the opinion, Vice Chancellor Lamb observed that "Delaware courts have never found
a material adverse effect to have occurred in the context of a merger agreement. This is
not a coincidence." The court cited both In re IBP, Inc. S'holders Litig., 789 A.2d 14
(Del. Ch. 2001), and Frontier Oil v. Holly Corp., No. Civ.A. 20502, 2005 WL 1039027
(Del. Ch. Apr. 29, 2005), and added to these precedents interpretative guidance that
underscores the extremely high bar faced by buyers who seek to terminate merger
agreements based on the assertion of a material adverse effect.
Party Asserting the Material Adverse Effect Has the Burden of Proof. Hexion
argued that Huntsman bore the burden of proof since the absence of a material adverse
effect was a condition to closing rather than a representation or warranty that no
material adverse effect had occurred. The court found that the burden rests with the
party seeking to excuse its performance under the contract, absent clear language to the
contrary. The court, in a footnote, suggested that since the allocation of the burden of
proof is often dispositive, parties should contractually "allocate explicitly the burden of
proof with respect to material adverse effect clauses."
Material Adverse Effect Must Generally Be Based on a Long-Term View. The court
reaffirmed prior case law in holding that, in the absence of contrary evidence, "a
corporate acquirer may be assumed to be purchasing the target as part of a long-term
strategy." As a result, the relevant question is "whether there has been an adverse
change in the target's business that is consequential to the company's long-term earnings
power over a commercially reasonable period, which one would expect to be measured
in years rather than months." "[P]oor earnings results must be expected to persist
significantly into the future" to constitute a material adverse effect.
Missed Forecasts Alone Are Not a Material Adverse Effect. Hexion argued that
Huntsman's shortfalls from its 2007 and partial 2008 EBITDA forecasts evidenced a
material adverse effect. But the court noted that the merger agreement "explicitly
disclaims any representation or warranty by Huntsman" with respect to any projections,
forecasts or other estimates. Because the parties had "specifically allocated the risk to
Hexion that Huntsman's performance would not live up to management's expectations at
the time," Huntsman's failure to meet projections did not constitute a material adverse
effect.
Huntsman's 2007 EBITDA was only 3% below its 2006 EBITDA, and 2008 would only
be 7% below its 2007 EBITDA, neither of which evidenced a material adverse effect.
The court found that future performance was likely to fall somewhere between Hexion's
pessimistic projections and Huntsman's somewhat optimistic ones, which was consistent
with analysts' expectations. Finally, the court found that Huntsman's net debt expansion
of approximately 5%-6% was not large enough to establish a material adverse effect and
was, in any event, consistent with Hexion's own projections, and that disappointing
results at two key Huntsman businesses were either part of normal cyclicality or likely
to be reversed in future periods.
The court then methodically reviewed Hexion's actions following Huntsman's poor
results to document a pattern of bad faith activity that amounted to a knowing and
intentional breach of Hexion's general obligation to use its reasonable best efforts to
consummate the merger and its specific obligations to obtain antitrust approvals and to
use its reasonable best efforts to consummate the financing.
Hexion was also obligated to keep Huntsman informed of "all material activity
concerning the status of" the financing, and specifically whether Hexion "no longer
believes in good faith that it will be able to obtain all or any portion" of the financing on
the commitment letter terms. In the court's view, Hexion's failure to communicate to
Huntsman its solvency concerns "both constitutes a failure to use reasonable best efforts
to consummate the merger and shows a lack of good faith."
Rather than keeping Huntsman informed of its financing concerns, Hexion acted in
secret to have an appraisal firm prepare the insolvency opinion. The court criticized
Hexion for failing to insulate the opinion team from knowledge that Hexion was
preparing for litigation, biasing its objectivity. The court enumerated the many ways
Hexion skewed the facts presented to the appraisal firm: reducing Huntsman's EBITDA
estimates without consulting Huntsman, adding a $102,000,000 Apollo advisory fee that
had not been included in prior deal models, and factoring in nearly $400,000,000 of
U.S. and U.K. pension liability payable at closing despite discussions with pension
authorities suggesting such payments would be unnecessary. The skewed input resulted
in a flawed document that the court ultimately found "unreliable."
Hexion Breached Its Antitrust Obligations. Hexion agreed to "take any and all action
necessary" to obtain antitrust approval for the merger, and not to take actions that
"could reasonably be expected to hinder or delay the obtaining" of such approval—a
"come hell or high water" obligation. Nevertheless, by the time of trial, Hexion had not
received antitrust clearance, despite having agreed in principle with the FTC staff on a
divestiture plan. Although Huntsman had certified its compliance with a second request
from the FTC, Hexion had failed to respond to interrogatories relating to the second
request. The court concluded that Hexion had been "dragging its feet" on obtaining
antitrust clearance, despite its "hell or high water" commitment.
The more extraordinary ruling was the court's sweeping grant of Huntsman's request for
specific performance of all Hexion's covenants precedent to closing and indefinite
extension of the merger agreement termination date to permit Hexion to comply with its
order. The court concluded that the merger agreement "somewhat unusually" prohibited
the issuance of an order specifically directing Hexion to comply with its duty to close
the transaction. But the court ordered Hexion to perform all its obligations short of
consummating the closing, including using its reasonable best efforts to satisfy the
terms of the commitment letter and consummate the financing and enjoined Hexion and
its affiliates from taking any further action "that could reasonably be expected to
materially impair, delay or prevent consummation" of the financing (emphasis omitted).
Finally, the court extended the termination date until five business days after the date
when the court should determine that Hexion had fully complied with the terms of its
order.
Following the ruling, Hexion obtained approvals for the merger from both the Federal
Trade Commission and the European Union. Hexion has also received from Apollo a
commitment for a $540 million capital infusion contingent on the merger and an
agreement to waive its transaction fee and other fees following the merger, both of
which should facilitate obtaining a solvency opinion for the combined entity.
Practical Tips
Directors of acquiring companies have responsibilities in connection with the termination of merger
agreements. The Hexion board of directors voted to approve the filing of the lawsuit against Huntsman after
concluding that the combined company risked insolvency. The court stated that, instead, it was the board's
duty "to explore the many available options for mitigating the risk of insolvency while causing the buyer to
perform its contractual obligations in good faith." Thus the board of directors of an acquirer who considers
terminating a merger agreement should carefully consider whether the company's actions could breach the
agreement and the potential damages against it if it proceeds. It is one thing to play "hardball" within the
scope of a negotiated agreement, but buyers who act in bad faith by knowingly disregarding their contractual
obligations may face significant consequences.
Parties may allocate the burden of proof regarding the existence of a material adverse effect.
Negotiators should consider adding contractual provisions allocating the burden of proof with respect to the
existence of a material adverse effect. As with other merger agreement terms, success will be a matter of
leverage.
"Reasonable best efforts" may require significant efforts. Drafters should recognize that a buyer's
contractual commitment to exert "reasonable best efforts" obligates the buyer to take all commercially
reasonable steps to satisfy the contract terms, to the point where there are "no viable options it could exercise
to allow it to perform without disastrous financial consequences." The modifier "reasonable" does not
encompass halfhearted effort, or none at all. disclaimer of representations regarding projections can,
effectively, be another carve-out to a material adverse effect clause. Buyers should be aware that, even
where the material adverse effect definition has no carve-out for the seller's failure to meet projections, a
relatively standard disclaimer of projections by the seller can be interpreted together with the material adverse
effect clause and can effectively create another carve-out to the definition of material adverse effect.
Buyers cannot "bootstrap" factors within their control to create a "ghost" financing out. Buyers must
realize that they cannot manipulate factors within their control—such as Hexion's creation of a skewed
solvency opinion and distribution of that opinion under circumstances designed to create a self-fulfilling
prophecy—to create a contractual "out" that they did not bargain for in the first instance. For a sophisticated
buyer to argue that performance is impossible and must be excused, when it created many of the barriers to its
performance, may constitute bad faith.