The Era of 'Busted Deals'?

The current financial environment has generated an atmosphere where not only are fewer “deals” taking place, but also many deals that are far down the path of consummation may fall apart. These “busted deals” started occurring in late 2007 and continue. As the demand for exit and acquisition financing continues to exceed the supply, it is safe to assume we will continue to see a number of “busted deals.”

Why Do Deals 'Bust'?

“Busted deals” have resulted for a variety of reasons, and occur both in and out of bankruptcy. The inability of lenders to syndicate loans has caused several Debtor-in-Possession (DIP) financings and Exit Financing financings to fail, with the result being an inability to reorganize or significant delays in exiting Chapter 11. Typically, lenders have relied on Material Adverse Change (“MAC”) clauses, alleged breaches of representations and warranties or the failure of closing conditions to terminate a commitment. The failure to obtain DIP financing will usually prevent a reorganization on an orderly sale of a business. In the case of certain recent retail bankruptcies, inventory has been sold on the “open market” for a significantly diminished price. Additionally, the loss of large numbers of businesses not only has an economic impact, but also a psychological impact on consumer confidence, resulting in lower overall spending.

“Busted” exit financing transactions also may generate a chain of negative events, including a delay in either the confirmation or effective date of the Plan of Reorganization. Such a delay can exacerbate the “cash burn” in a troubled company and greatly increase administrative costs. The two most prominent bankruptcy cases involving “busted deals” are Solutia and Delphi.

In Solutia, the debtor obtained a commitment for exit financing in October, 2007 from Citibank and other lenders. In January, 2008, the lenders declared a market Material Adverse Change, citing growing problems in the credit market resulting in an inability to syndicate the loan. Solutia commenced litigation seeking specific performance and monetary damages. Solutia argued that there had been no adverse change in the market within the meaning, and subsequent to the execution, of the commitment letter. It also argued that the agent assumed the syndication risk. The lenders argued that the market MAC was plain, clear and unambiguous. Less than a month later, the parties reached a settlement by modifying both the interest rates and the amounts advanced.

In Delphi, the debtor, Appaloosa and other investors executed a post-petition investment agreement which was a key component of the Delphi Plan of Reorganization. Under the investment agreement, Delphi was obligated to obtain exit financing, and the investors had approval rights with respect to certain aspects of the financing. Initially, Appaloosa objected to the exit financing, arguing that General Motors was not a proper loan party. The court agreed with Appaloosa, but suggested that GM affiliates might be proper lending parties. Ultimately, Appaloosa terminated its commitment on the closing date of the transaction. Delphi then filed suit against Appaloosa, and Appaloosa moved to dismiss. The court granted the motion to dismiss in part and denied the motion in part. The litigation continues and Delphi remains unable to exit Chapter 11 despite a confirmed Plan of Reorganization.

Failed 'Healthy' Transactions

There have also been several failed “healthy” merger and acquisition transactions, including Hexion/Huntsman (Hexicon Specialty Chemicals v. Huntsman Corp., 2008 WL 445-544 (Del. Ch. 2008)), and United Rentals (United Rentals, Inc. v. RAM Holdings, Inc., 937 A. 2d 810 (Del. Ch. 2007)) In each case, contract disputes arose involving the terminated merger and sale agreements.

Hexicon initiated litigation seeking a declaratory judgment that it was justified in terminating its merger agreement with Huntsman. Hexion relied upon a Material Adverse Event (“MAE”) allegedly triggered by Huntsman's poor quarterly performance and a valuation showing the combined entity would be insolvent. The court rejected Hexicon's reasons for termination. Significantly, the court stated that in “determining whether an MAE has occurred, changes in corporate fortune must be examined in the context in which the parties were transacting ' [an] important consideration therefore is whether there has been an adverse change in the target's business that is consequential to the company's long-term earning power over a commercially reasonable period ' measured in years, not months.” After the ruling, the parties settled and Huntsman was paid $1 billion.

In United Rentals, a suit was filed against RAM after it attempted to terminate the merger agreement. Although RAM agreed to pay the $100 million break-up fee under the agreement, RAM sought specific performance. Ultimately, the court concluded that the ambiguity in the conflicting remedy provisions (specific performance vs. break-up fee) demonstrated there was no meeting of the minds, and United was not entitled to specific performance.

A busted deal often has an impact that extends beyond the primary parties to the transaction. In some cases, shareholders of, and investors in, the “target” company may pursue securities and class action lawsuits when a deal busts.

What Contributes to the Likelihood of a 'Busted Deal'?

In a rapidly declining market and a recession, companies may well look less and less attractive for the following reasons:

• Weakening performance of the company;
• Lower valuation of debt;
• Increase in debt level;
• Decrease in stock price;
• Decrease in market share;
• Erosion of the customer base;
• Increased customer and supplier insolvencies; and
• Increase in the accounts receivable collection period.

A lender or acquirer would be well advised to specifically delineate such events in order to maximize the likelihood of successfully relying on such events to terminate a loan commitment or merger agreement.

Conclusion

Given the current environment, both companies and lenders must be even more diligent in drafting commitment letters, with particular emphasis on MAC clauses, reps and warranties and conditions to closing. To the greatest extent possible, the terms of the commitment should be plain, clear and unambiguous. This will minimize, if not eliminate, the ability of parties to seek to admit parol evidence concerning the parties' intentions. MACs should be as explicit as possible and not treated as mere boilerplate. As the economic recession continues, it will be more difficult for a party to rely on boilerplate MAC clauses and argue successfully that market MACs may be employed to terminate commitments.

Matthew J. Botica is a partner in the Chicago office of Winston & Strawn LLP. He has more than 30 years of experience representing debtors, institutional lenders, creditors' committees, trustees, governmental agencies, and other creditors in the bankruptcy, reorganization, and claims trading areas. Botica may be reached at [email protected].

The current financial environment has generated an atmosphere where not only are fewer “deals” taking place, but also many deals that are far down the path of consummation may fall apart. These “busted deals” started occurring in late 2007 and continue. As the demand for exit and acquisition financing continues to exceed the supply, it is safe to assume we will continue to see a number of “busted deals.”

Why Do Deals 'Bust'?

“Busted deals” have resulted for a variety of reasons, and occur both in and out of bankruptcy. The inability of lenders to syndicate loans has caused several Debtor-in-Possession (DIP) financings and Exit Financing financings to fail, with the result being an inability to reorganize or significant delays in exiting Chapter 11. Typically, lenders have relied on Material Adverse Change (“MAC”) clauses, alleged breaches of representations and warranties or the failure of closing conditions to terminate a commitment. The failure to obtain DIP financing will usually prevent a reorganization on an orderly sale of a business. In the case of certain recent retail bankruptcies, inventory has been sold on the “open market” for a significantly diminished price. Additionally, the loss of large numbers of businesses not only has an economic impact, but also a psychological impact on consumer confidence, resulting in lower overall spending.

“Busted” exit financing transactions also may generate a chain of negative events, including a delay in either the confirmation or effective date of the Plan of Reorganization. Such a delay can exacerbate the “cash burn” in a troubled company and greatly increase administrative costs. The two most prominent bankruptcy cases involving “busted deals” are Solutia and Delphi.

In Solutia, the debtor obtained a commitment for exit financing in October, 2007 from Citibank and other lenders. In January, 2008, the lenders declared a market Material Adverse Change, citing growing problems in the credit market resulting in an inability to syndicate the loan. Solutia commenced litigation seeking specific performance and monetary damages. Solutia argued that there had been no adverse change in the market within the meaning, and subsequent to the execution, of the commitment letter. It also argued that the agent assumed the syndication risk. The lenders argued that the market MAC was plain, clear and unambiguous. Less than a month later, the parties reached a settlement by modifying both the interest rates and the amounts advanced.

In Delphi, the debtor, Appaloosa and other investors executed a post-petition investment agreement which was a key component of the Delphi Plan of Reorganization. Under the investment agreement, Delphi was obligated to obtain exit financing, and the investors had approval rights with respect to certain aspects of the financing. Initially, Appaloosa objected to the exit financing, arguing that General Motors was not a proper loan party. The court agreed with Appaloosa, but suggested that GM affiliates might be proper lending parties. Ultimately, Appaloosa terminated its commitment on the closing date of the transaction. Delphi then filed suit against Appaloosa, and Appaloosa moved to dismiss. The court granted the motion to dismiss in part and denied the motion in part. The litigation continues and Delphi remains unable to exit Chapter 11 despite a confirmed Plan of Reorganization.

Failed 'Healthy' Transactions

There have also been several failed “healthy” merger and acquisition transactions, including Hexion/Huntsman (Hexicon Specialty Chemicals v. Huntsman Corp., 2008 WL 445-544 (Del. Ch. 2008)), and United Rentals ( United Rentals, Inc. v. RAM Holdings, Inc. , 937 A. 2d 810 (Del. Ch. 2007)) In each case, contract disputes arose involving the terminated merger and sale agreements.

Hexicon initiated litigation seeking a declaratory judgment that it was justified in terminating its merger agreement with Huntsman. Hexion relied upon a Material Adverse Event (“MAE”) allegedly triggered by Huntsman's poor quarterly performance and a valuation showing the combined entity would be insolvent. The court rejected Hexicon's reasons for termination. Significantly, the court stated that in “determining whether an MAE has occurred, changes in corporate fortune must be examined in the context in which the parties were transacting ' [an] important consideration therefore is whether there has been an adverse change in the target's business that is consequential to the company's long-term earning power over a commercially reasonable period ' measured in years, not months.” After the ruling, the parties settled and Huntsman was paid $1 billion.

In United Rentals, a suit was filed against RAM after it attempted to terminate the merger agreement. Although RAM agreed to pay the $100 million break-up fee under the agreement, RAM sought specific performance. Ultimately, the court concluded that the ambiguity in the conflicting remedy provisions (specific performance vs. break-up fee) demonstrated there was no meeting of the minds, and United was not entitled to specific performance.

A busted deal often has an impact that extends beyond the primary parties to the transaction. In some cases, shareholders of, and investors in, the “target” company may pursue securities and class action lawsuits when a deal busts.

What Contributes to the Likelihood of a 'Busted Deal'?

In a rapidly declining market and a recession, companies may well look less and less attractive for the following reasons:

• Weakening performance of the company;
• Lower valuation of debt;
• Increase in debt level;
• Decrease in stock price;
• Decrease in market share;
• Erosion of the customer base;
• Increased customer and supplier insolvencies; and
• Increase in the accounts receivable collection period.

A lender or acquirer would be well advised to specifically delineate such events in order to maximize the likelihood of successfully relying on such events to terminate a loan commitment or merger agreement.

Conclusion

Given the current environment, both companies and lenders must be even more diligent in drafting commitment letters, with particular emphasis on MAC clauses, reps and warranties and conditions to closing. To the greatest extent possible, the terms of the commitment should be plain, clear and unambiguous. This will minimize, if not eliminate, the ability of parties to seek to admit parol evidence concerning the parties' intentions. MACs should be as explicit as possible and not treated as mere boilerplate. As the economic recession continues, it will be more difficult for a party to rely on boilerplate MAC clauses and argue successfully that market MACs may be employed to terminate commitments.

Matthew J. Botica is a partner in the Chicago office of Winston & Strawn LLP. He has more than 30 years of experience representing debtors, institutional lenders, creditors' committees, trustees, governmental agencies, and other creditors in the bankruptcy, reorganization, and claims trading areas. Botica may be reached at [email protected].